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Consequently the valuation is an iterative process

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Unformatted text preview: re the values obtained when the valuation is performed using formula [1]. Consequently, the valuation is an iterative process: The free cash flows are discounted at the WACC to calculate the company’s value (D+E), but in order to obtain the WACC we need to know the company’s value (D+E). Method 2. Using the expected equity cash flow (ECF) and the required return on equity (Ke). Equation [3] indicates that the value of the equity (E) is the present value of the expected equity cash flows (ECF) discounted at the required return on equity (Ke). [3] E0 = PV0 [Ket; ECFt] Equation [4] indicates that the value of the debt (D) is the present value of the expected debt cash flows (CFd) discounted at the required return on debt (Kd). [4] D0 = PV0 [Kdt; CFdt] The expression that relates the FCF with the ECF is: [5] ECFt = FCFt + ∆Dt - It (1 - T) ∆Dt is the increase in debt, and It is the interest paid by the company. It is obvious that CFdt = It - ∆Dt. Obviously, the free cash flow is the hypothetical equity cash flow when the company has no debt. The sum of the values given by equations [3] and [4] is identical to the value provided by [1]: E0 + D0 = PV0 [WACCt; FCFt] = PV0 [Ket; ECFt] + PV0 [Kdt; CFdt]. Indeed, one way of defining the WACC is: The WACC is the rate at which the FCF must be discounted so that equation [2] gives the same result as that given by the sum of [3] and [4]. Method 3. Using the capital cash flow (CCF) and the WACCBT (weighted average cost of capital, before tax). Arditti and Levy (1977) suggested that the firm’s value could be calculated by discounting the capital cash flows instead of the free cash flow. The capital cash flows are the cash flows available for all holders of the company’s securities, whether these be debt or shares, and are equivalent to the equity cash flow (ECF) plus the cash flow corresponding to the debt holders (CFd). IESE Business School-University of Navarra - 3 Equation [6] indicates that the value of the debt today (D) plus that of the shareholders’ equity (E) is equal to the capital cash flow (CCF)...
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