Ch.19 Valuations - income based approaches

Question 1

Capitalized cash flow approach

Answer 1

used under the following circumstances:
• The entity is a going concern and has active operations.
• The historical results of the entity are reflective of anticipated future operating results.
• The entity does not prepare reliable financial projections.

Question 2

Step 1: Estimate maintainable operating cash flow (EBITDA)

Answer 2

normalize the entity’s income for any one-time or non-recurring revenue or expense items
normalized income amount is then adjusted for the following:
• Interest is added back to obtain unlevered (before the cost of financing) cash flows.
• Amortization expense is added back to get to a cash basis.
• Income taxes are added back
=estimated maintainable operating cash flow (earnings before interest, tax, depreciation, and amortization, or EBITDA) for the historical period.

Question 3

Steps 2: Deduct income taxes

Answer 3

Income taxes are determined by applying the appropriate tax rate to EBITDA determined in Step 1.

Question 4

Step 3: Deduct sustaining capital reinvestment (net of present value of capital cost allowance tax shield)

Answer 4

are the outlay for capital assets required each year to maintain operations at existing levels. Because there is an associated tax saving resulting from the purchase of these capital assets, this expenditure is recognized net of the tax shield.
The net of Steps 1, 2, and 3 is the estimated maintainable free cash flow balance (the remaining cash flow that can be reinvested in the company, used to pay debt, or paid to shareholders).

Question 5

Steps 4 and 5: Divide estimated maintainable free cash flow by the capitalization rate to calculate capitalized cash flows

Answer 5

estimated maintainable free cash flow amount is then divided by the capitalization rate to determine the value of capitalized cash flows. The capitalization rate is the measure of the risk (discount rate) and constant growth rate. The capitalization rate that is often used in practice is the weighted average cost of capital (WACC).
If the valuator is using a high and low range of maintainable free cash flow, the valuator will also use a range for WACC. Higher maintainable free cash flow is capitalized by dividing by the higher WACC. A higher WACC is used for higher free cash flows, as they are inherently riskier than lower cash flows.

Question 6

Step 6: Add the present value of the existing tax pools

Answer 6

add the present value of the tax savings from the current asset base (existing income tax pools). The purchaser of the shares or the assets is a taxable entity; therefore, the ability to use the existing tax pools represents incremental value.

Question 7

Step 7: Add redundant assets and subtract redundant liabilities

Answer 7

Redundant assets (if any) are added and redundant liabilities (if any) are deducted
If a redundant asset or liability is identified, the valuator must also ensure that any corresponding income statement impact is normalized for in determining EBITDA in Step 1 above.

Question 8

redundant assets

Answer 8

Redundant assets are tangible and intangible assets that are not required by the business to generate operating cash flows. The NRV of redundant assets is added to the value of the company under income-based valuation approaches.

Question 9

redundant liab

Answer 9

Redundant liabilities may be directly related to redundant assets, or they may simply be liabilities not associated with the operations of the business. Redundant assets and liabilities are normally identified via a detailed review of the balance sheet of the business.

Question 10

Step 8: Deduct interest-bearing debt

Answer 10

If the company has interest-bearing debt, the value of this debt must be deducted to arrive at an acceptable range of equity values for the company.