Finance - Valuation - Income, Cash Flow, Market Based Approached

Question 1

How is the capitalized cash flow valuation approach commonly used

Answer 1

1. Entity is a going concern and has an active operation
2. Historical results of the entity reflect anticipated future operating results with the constant annual future growth rate
3. Entity does not prepare a reliable financial projection

Question 2

What are the types for capitalized cash flow approach

Answer 2

1. Maintainable operation cash flows (EBITDA)
   Deduct
2. Income taxes
   Deduct
3. Sustaining capital investment (NPV of tax shield)
   Deduct
4. Capitalization rate
   Equal
5. Capitalized cash flows
   Add
6. Present value of the existing tax pool
   Add
7. Redundant asset net of redundant liabilities
   Deduct
8. Outstanding interest bearing debt
   Equals
   Equity value

Question 3

Explain the first 5 steps of valuation for capitalized cash flow

Answer 3

1. Estimate maintainable operating cash flow (EBITDA)
   - To normalize the entity’s income for any one-time non-recurring revenue or expense item.
   The normalized income amount is adjusted to
   - Interest is added back to obtain unleveraged cash flow
   - Amortization and depreciation expenses are added back to obtain a cash basis
   - Income taxes are added back
2. Deduct income tax - use the appropriate tax rate
3. Deduct sustaining capital reinvestment ( NPV of CCA tax shield)
   - The outlay for capital assets required each year to maintain operation at existing levels.

4 and 5 - Divide estimated maintainable free cash flow by the capitalization rate to calculate capitalized cash flow
- Capitalization rate based on measure of risk (discount rate) and constant growth rate
- Valuator using a high and low range of maintainable free cash flow, used WACC

Question 4

Explain the last three steps for determining capitalized cash flow approach

Answer 4

1. Add the present value of existing tax pools
   - Determining the value of capitalized cash flow, the evaluator will add the PV of tax savings from current asset base
2. Add redundant asset and subtract redundant liabilities
   - Redundant asset - tangible or intangible assets that are not required by the business to generate operating cash flow.
   - Redundant liabilities - can be directly related to redundant asset, or simply liabilities not associated with the operation of the business
3. Deduct interest-bearing debt
   - Interest bearing, current market value of this debt must be deducted to arrive

Question 5

What are the steps to perform for capitalized earning approach

Answer 5

1. Determine the types of income to be capitalized, such as:
   -EBITDA,
   - Earnings before interest and taxes
   - Net profit after tax
   - Free cash flow
2. Prepare a recast statement of earnings, based on historical earnings normalized for known anomalies that are not representative of future earning
3. Choose a capitalization rate that is appropriate for the income measurement being used, which is in its inverse form( 1/ capitalization rate)
4. Calcualte the investment value.

Question 6

Explain what the discounted cash flow approach is

Answer 6

-DCF, approach is the preferred approach for valuing a business, as it includes a detailed analysis of key forecast and valuation variables
- Issues, lack of regularly prepared forecasts, and the unreliability of the assumption
- Commonly prepared projection but cannot show that its historical results have been in line with this projection

Steps in DCF approach
(Investment * CCA rate * corporate tax rate)/ (CCA rate + discount rate )
*
(1+1.5*discount rate)/ (1+ discount rate)

Question 7

What are the steps to determine the discounted cash flow approach

Answer 7

1. Estimate the PV of annual free cash flow
   - Interest expense is added back to obtain unlevered cash flow
   - Amortization/ depreciation expense is added back
   - Taxes on the earnings are deducted
   - Sustaining capital expenditures, net of their associated tax shield
2. Add the present value of the terminal or residual value
3. Add the present value of the existing tax shield on existing asset

4 and 5. Add the NRV of redundant asset, less redundant liabilities and deduct interest bearing debt