- attempt to estimate the expected cash flows that will be generated by combination- usually include very specific assumptions - period where abnormal growth occurs – the period of time when the company isexpected to yield a competitive advantage.- after the competitive advantage is exhausted the constant growth is included in the terminal value calculation2.)Terminal Value - based on the final cash flow estimated during the forecast period- constant growth assumption and indefinite period of time- perpetual flow of constantly growing cash flows = estimation of the present value of the cash flows generated after the forecast period.NB! When working with calculation of the terminal value – conservative assumptions must be madeSince valuation happens over a long period of time – small changes have a profound effect.2 | P a g eTerminal Value = FCFtx ( 1 + g ) ( WACC – g )FCFt= the free cash flow during the final year of the forecast period consisting of t yearsg = the constant growth rate assumed after the forecast period WACC = the company’s weighted cost of capital
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Calculating Free Cash Flow-Step 1 – estimate the expected free cash flow ( amount available to company’s capital providers after provision for investments in fixed and working capital)-During the process of estimating FCF – focus is placed on determining the operating cash flow attributable tothe business combination-These calculations include any changes in income and expenses as well as assets due to the combination 3 | P a g eExample ( Page 110 )Assume that the board of directors of WCB Ltd. is considering other expansion investments, and identified a target company that would enable them to achieve the desired expansion. They approached you to calculate a value for this company, Beta Ltd., which they could use as an estimate of the fair value of the acquisition. Beta Ltd.’s WACCamounts to 10%.As part of your analysis, you forecasted Beta Ltd.’s free cash flow (FCF) for the next five years, and after Year 5, a constant growth rate of 5% is assumed. Your FCF estimations for the next five years are as follows:Currently Year 1 Year 2 Year 3 Year 4 Year 5FCF10 000 12 000 15 000 19 000 22 000 24 000Step 1– calculate terminal value FCF5x (1 + g)= 24000 x ( 1 + 0.05 )= R504 000 (WACC- g)( 0.10 – 0.05 )Step 2– calculation of company value CF1= 12000CF2= 15000CF3= 19000CF4= 22000CF5= 528000 (24000 + 504000)i = 10%NPV = ?? R380 453.52FCF = EBIT (1-T) + NCI – CAPEX – ΔNOWCEBIT= earnings before finance costs (interest) and tax T= marginal tax rateNCI= Non-Cash Items , like depreciations, amortisation and impairment of goodwillCAPEX= capital expenditure on fixed assets ΔNOWC= change in the net operating working capital (trade receivables, trade payables, inventory)
4 | P a g eExample (Page 112)Suppose that WCB Ltd. identified another potential target company that is operating in an unrelated industry.
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