ACOVA RADIATUERS

ECF and CCF Valuation

Applying DCF Techniques Word

of Caution
With

low leverage,

It does not matter whether one

values equity directly or as assetsminus-debt
Equity may be evaluated directly, by
discounting expected equity cash
flows at the cost of equity
What

if the leverage is high and

the amount of debt changes over

High levered Firm The concerns

Though

firm is solvent, default is

more likely
Valuing the assets is a bit trickier
because of more and riskier tax
shields and high cost of financial
distress
Structure of a typical long-term
debt contract creates multiple
call
options
with
complex
characteristics

ECF Method An Example

Suppose

an LBO firm has tentatively agreed to

pay $1.1 billion to acquire a certain business. The
managers of the business anticipate EBIT of $125
million for the coming year and this is expected to
grow in perpetuity at 3% per year. The LBO
sponsors are confident that they can raise $900
million in debt financing, provided they contribute
$200 million of equity and that all excess cash
generated by the business is used to pay down
debt. The sponsors expect to divest their holdings
after five years. Should they invest the $200
million and acquire the business? In other words,
is the equity worth more than $200 million?

Assumptions
Tax

rate is 36%;
Interest rate on the debt is 7%;
Capital expenditures equal depreciation
(both grow at 3% per year);
Additions to net working capital start at
$10 million in year 1 and grow at 3%.
Risk-free rate of 4%,
A market risk premium of 6%,
An asset beta of 0.85, and
A perpetuity growth rate of 3%

Calculation of FCFF, FCFE & FCFD

FCFF

FCFE

EBIT (1-t)

Net
Income

Depreciation

CAPEX

(-)

(-)

Changes in WC

+/(-)

+/(-)

FCFD

Adjustments:

Interest
Principal
Repayment
New Debt
Proceed

+
-

(-)

Financial Projection

Backward Induction
Method

Discounted ECF Completed

Analysis

Valuation method step-bystep

Step

1: Calculate Cash Flow Available

(CFA) = NI + Depreciation Cap Ex - NWC.
Step 2: Find Equity Cash Flows
CFA Principal Repaid + New Debt Proceeds,
which is set equal to zero by construction
Step 3: Estimate terminal value of the firm,
subtract book value of outstanding debt to
get terminal equity value
Step 4: Compute the IRR of BCIs anticipated
equity investment. Compare to the required
hurdle rate

ECF Method Pros and

Cons
Any

DCF technique is flawed when debt is risky

When debt is riskless, ECF produces correct
value
Still better in LBOs as the discount rate is high
ECF
Provides a biased estimate of firm value when debt is
risky,
the sign of the bias is known, and
the magnitude of the bias can be calculated
WACC

and APV - incorporate the promised tax

shield, rather than the expected tax shield

Case ACOVA
RADIATUERS

BCIs smiling points

IRR

of 43% (Exhibit 5B)

30-35%

is the right hurdle rate

Investment
Why

seems overwhelming

to have a relook????

The IRR Trap

30-35%

is a sufficient
compensation for the risk
NPV of high risk projects may be
negative
Reject some low risk projects
with positive NPVs

Some Concerns in Foreign

Setting
Which

Risk Free Rate France or

US
Which

Risk Premium Depends

on integration

Can

use US premium

Rule of Thumb
What

should be the beta?

- Beta of 1.0 for an average firm

- 1.0 represents the average levered beta
- average unlevered beta is closer to 0.7 or
0.8
- Figure may be higher for specialty business
How

to calculate WACC when KA is

known?
Rule of thumb WACC KA 1%
KA = 10.06+(0.9)(7.43) = 16.75%

ECF TV on Multiples

CCF Method of Valuation

Value CCF Method