Consistent Methods of Valuing Companies By Dcf: Methods and Assumptions
21 Pages Posted: 18 Aug 2006
Date Written: August 2006
In this note we discuss four common methods of valuing firms:
1.Discounting operating free cash flow at the weighted average cost of capital.
2.Discounting equity free cash flow at the cost of equity.
3.Valuing the firm using adjusted present value.
4.Discounting the capital cash flow at the unlevered cost of capital.
We examine four alternative assumptions about leverage policy and how they affect three things: discount rates, the present value of tax savings, and how to use the above methods. We describe alternative ways of implementing the valuation methods consistently, and how to choose between them. Finally, we show how inconsistent application can lead to errors that are subtle but large. The use of incorrect formulas can result in an estimate of the present value of the tax saving that is double its correct value.
Keywords: discounted cash flow, APV, WACC, leverage policy, value of tax shields, equity cash flow
JEL Classification: G12, G31, G32, M21
Suggested Citation: Suggested Citation