Set 4 FI 19 Valuations: Income-Based Approaches

Question 1

8 steps of capitalized cash flow approach

Answer 1

1. Estimate EBITDA
2. Deduct income taxes
3. Deduct sustainable capital reinvestment (net of PV of CCA tax shield)
   This determines free cash flow.
4. Divide this by capitalization rate
5. Add PV of existing tax pools
6. Add redundant assets and subtract redundant liabilities.
7. Deduct interest-bearing debt.

Question 2

how to estimate EBITDA

Answer 2

income is normalized (as in audit), then:
1. interest added back to determine unlevered cash flows.
2. depreciation added back.
3. income taxes added back.
typically there will be a range

Question 3

what is used for capitalization rate?

Answer 3

typically WACC. again, can use a range

Question 4

define redundant assets

Answer 4

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

Question 5

steps in DCF approach (4/5)

Answer 5

1. Estimate PV of annual free cash flows
2. Add PV of terminal or residual value
3. Add PV of existing tax shield on existing assets.
4. Add NRV of redundant assets, less redundant liabilities and deduct interest-bearing debt.

Question 6

how is EBITDA determined

Answer 6

normalized income projected over a discrete period.
• Interest expense is added back to obtain unlevered cash flows.

• Amortization/depreciation expense is added back.
• Taxes on the earnings are deducted.
• Sustaining capital expenditures, net of their associated tax shield, are deducted.
• Working capital investments are deducted.

This determine free cash flow - this is then discounted to PV using WACC

Question 7

terminal or residual value

Answer 7

The next step involves determining the terminal or residual value for the company. A terminal value is used when the company is assumed to exist into perpetuity, and a residual value is used when a disposal is assumed.

The go-forward free cash flows are estimated for one period at the end of the discrete period and are then capitalized by multiplying by the capitalization multiple (determined as 1 / capitalization rate) to determine the undiscounted residual value. This terminal or residual value is then discounted to the present using the associated discount rate (that is, WACC).

Question 8

capitalization rate calculated as

Answer 8

WACC discount rate minus long-term growth rate

Question 9

when are market-based approaches not appropriate?

Answer 9

This method is not appropriate if insufficient data is available or if data is available but there is limited comparability to the company that is being valued

Question 10

what are some factors that determine if companies and transactions are comparable

Answer 10

size
geographic region
growth prospects
industry similarity
financial risks
dividend paying ability

Question 11

key valuation multiples used?

Answer 11

equity compared with earnings
book value
net tangible assets

enterprise value compared with
revenues
EBITDA
EBIT

Question 12

steps in capitalization of earnings approach

Answer 12

1. determine type of earnings to be capitalized, such as EBITDA, free cash flow etc.
2. prepare a recast statement based upon historical earnings normalized for known anomalies
3. choose a capitalization rate, which in inverse form is called a multiple.
4. calculate investment value.