Business Valuation: Income

Approach to Valuation
By: APL, CPA
Objectives:
• Introduction to Income Approach
• Expected Cash Flow
• Determining the appropriate Discount Rates that reflects the
riskiness of Cash Flow
• The Capital Asset Pricing Model
• Weighted Average Cost of Capital
Introduction to Income Approach
• It is an absolute valuation approach that estimates the value of an
asset based on its ability to generate future income for investors.
• Its underlying logic is that when we invest in an asset, we hope to
receive income, usually in the form of cash flows.
• DCF Method (Discounted Cash Flow Method). It requires us to
forecast the asset’s future cash flows and to apply a discount rate to
discount these series of future cash flows to a present value.
Deriving an estimated value from such a forecast requires an
understanding of two important concepts:
• Time Value of Money
• Greater discount rate for higher degree of risk
Introduction to Income Approach
• To value, it focuses on this main formula:
Introduction to Income Approach
• To value, it focuses on this main formula:
Expected Cash Flow: Dividends
• When we invest in a company’s shares, the returns expected
include dividends and the price of the shares when we sell
them. The future selling price should also reflect the value of the
remaining expected future dividends from then onwards.
• Formula:
Expected Cash Flow: Dividends
• Constant Growth Dividend
One whose dividends are expected to grow forever at a constant growth
rate, (g).

• Nonconstant Growth Dividends

Opposite definition of Constant growth Dividends

• Perpetuity
Dividends is given at a fixed rate (i.e. Preferred Dividends). Here growth
rate is equal to ZERO.
Expected Cash Flow: Dividends
• D1 = D0(1 + g)1
• D2 = D0(1 + g)2
• Dt = Dt(1 + g)t

If g is constant, then:

D0(1 + g) D1
P0 = = .
ks – g ks – g
Illustration:
D0 was $2.00 and g is a constant 6%. Find the expected dividends for the
next 3 years, and their PVs. r(ks )= 13%.
0 g = 6% 1 2 3

D0 = 2.00 2.12 2.247 2.382

D1 $2.12 $2.12
P0 = = = = $30.29.
ks – g 0.13 – 0.06 0.07
If we have supernormal growth of 30% for 3 years, then a long-
run constant g = 6%, what is P0? k(r) is still 13%.
Nonconstant growth followed by constant growth:

0 1 2 3 4
ks = 13%
...
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.600 3.380 4.394 4.658

2.301
2.647
3.045 Terminal Value
! 4.658
.
46.114 P3 = = $66.54
^ 0 .13 - 0.06
54.107 = P0
What would P0 be if g = 0?
The dividend stream would be a perpetuity.

0 1 2 3
13% ...
2.00 2.00 2.00

^ PMT $2.00
P0 = = = $15.38.
k 0.13
Expected Cash Flows: Free
cash flows to Equity (FCFE)
Formula:
Formula:
EBIT
-Interest
- Tax (based on EBIT)
+ Non-cash operating expenses
- Capital Expenditure
+/- Net Change in Working Capital
- Debt principal repaid
+ New debt borrowed
-----------------------------------------------
= Free Cash Flow to Firm (FCFF)
Non-cash Operating Expense
• Non-cash operating expenses are expenses that are included in the
calculation of net profit but require no cash outlay.
• They are included because the net profit in a profit and loss statement is
calculated on an accrual basis in accordance with generally ac-cepted
accounting principles (GAAP).
• The aim is to match revenues with the expenses incurred in generating
them to derive firm performance in terms of profits for the measurement
period.
• Net profit is therefore not equal to the cash flow generated.
Net change in Working Capital
• Working capital is defined as current assets less current liabilities.
• Current assets include cash, cash equivalents and assets that are
expected to be liquidated (i.e., turned into cash, such as accounts receiv
• An increase in working capital, which is a net investment in current assets,
represents the outflow of cash necessary to support the company’s
[Link]) or consumed during the next 12 months (i.e., inventory).
Debt Principal Repaid and New Debt
Borrowed
• Because the FCFE is the cash flow available to shareholders,
we need to subtract the interest and loan principal paid to
creditors. Any increase in borrowing represents a source of
cash inflow for shareholders and is thus added to the
calculation of the FCFE.
Capital Expenditures
• Are investments in the form of Property, Plant, and Equipment.
Expected Cash Flows: Free
cash flows to Firm (FCFF)
Formula:
Formula:
EBIT
- Tax (based on EBIT)
+ Non-cash operating expenses
- Capital Expenditure
+/- Net Change in Working Capital
-----------------------------------------------
= Free Cash Flow to Firm (FCFF)
Non-cash Operating Expense
• Non-cash operating expenses are expenses that are included in the
calculation of net profit but require no cash outlay.
• They are included because the net profit in a profit and loss statement is
calculated on an accrual basis in accordance with generally ac-cepted
accounting principles (GAAP).
• The aim is to match revenues with the expenses incurred in generating
them to derive firm performance in terms of profits for the measurement
period.
• Net profit is therefore not equal to the cash flow generated.
Net change in Working Capital
• Working capital is defined as current assets less current liabilities.
• Current assets include cash, cash equivalents and assets that are
expected to be liquidated (i.e., turned into cash, such as accounts receiv
• An increase in working capital, which is a net investment in current assets,
represents the outflow of cash necessary to support the company’s
[Link]) or consumed during the next 12 months (i.e., inventory).
Debt Principal Repaid and New Debt
Borrowed
• Because the FCFE is the cash flow available to shareholders,
we need to subtract the interest and loan principal paid to
creditors. Any increase in borrowing represents a source of
cash inflow for shareholders and is thus added to the
calculation of the FCFE.
Capital Expenditures
• Are investments in the form of Property, Plant, and Equipment.
Appropriate Discount Rates
Matching of Expected Cash flows and discount rates
Expected Cash Flow Discount Rate
Dividends Cost of equity
FCFE Cost of equity
FCFF Weighted Average Cost of Capital
Illustrative no. 1
 Illustrative no. 2

5.6
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠 =
(20% − 10%)

= 56
 Illustrative no. 3

180,000
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠 =
(11.5% − 6.5%)

= 3,600,000
Illustrative no. 4
Cost of Capital
• CAPITAL COMPONENT- The investor-supplied items-debt,
preferred stock, and common equity.

• COST OF CAPITAL- It is the required rate of return on the various

types of financing. The overall cost of capital is a weighted average
of the individual required rates of return (Costs). It is composed of
the following:
• After-Tax Cost of Debt (𝒓𝒅 (𝟏 − 𝑻))
• Cost of Preferred Stock (𝒓𝒑 )
• Cost of Common Stock- which could either be:
• Cost of Retained Earnings (𝒓𝒔 )
• Cost of New Common Stock (𝒓𝒆 )
• The Weighted Average Cost of Capital can be computed through
the following formula:
• WACC = 𝑾𝒅 (𝒓𝒅 (𝟏 − 𝑻)) + 𝑾𝒑 (𝒓𝒑 ) + 𝑾𝒄 (𝒓𝒔 )
Cost of Debt
• AFTER-TAX COST OF DEBT – it is the after tax required rate of return on
investment of the lenders of a company.
• Ignores accounts payable, accrued expenses, and other obligations not
having an explicit interest cost.
• Following the Maturity Matching Approach to project financing, the firm will
finance a capital project, whose benefits extend over a number of years,
with financing that is generally long term in nature. Therefore, interest cost
of a long- term debt is generally used as the cost of debt. With this, 𝒓𝒅 =
YTM.
• In order to solve YTM:
(1−(1+𝑌𝑇𝑀)−𝑡 )
• 𝑃0 = 𝑃(1 + 𝑌𝑇𝑀)−𝑡 + 𝑃𝑀𝑇 𝑌𝑇𝑀
• TN: Cost of deb must be after tax since interest expense is tax deductible.
When a company pays interest, the actual cost is less than the expense.
Illustration:
The DIET Company’s currently outstanding bonds have a 10%
coupon and a 12% yield to maturity. DIET believes it could issue
new bonds at par that would provide a similar yield to maturity. If
its marginal tax rate is 35%, What is DIET’s after-tax cost of
debt?
Cost of Preferred Stock
• COST OF PREFERRED STOCK – it is the required rate of
return on investment of the preferred shareholders of the
company.
• Since cost of preferred stock is already an after-tax figure-
preferred stock dividends being paid after tax, the explicit cost
of preferred stock is greater than that for debt.
• Formula:
𝐷𝑝
• 𝑟𝑝 =
𝑃0
• Growth is not included as preferred stocks pay out fixed
dividends.
Illustration:
ALO Industries can issue perpetual preferred stock at a price of
$47.5 a share. The stock would pay a constant annual dividend
of $3.80 a share. What is the company’s cost of preferred stock?
Cost of Equity
• COST OF EQUITY – It is the marginal cost of common equity
using retained earnings. It may also be the rate of return
investors require on the firm’s common equity using new equity
• Cost of Retained Earnings
• Cost of New Common Stock
Cost of Equity: Cost of retained earnings
• A firm can choose to finance new projects using only internally
generated funds (retained earnings).
• There is a cost of retained earnings because RE funds are not
free as they belong to the shareholders, hence there is an
opportunity cost where investors could buy similar stocks and
earn or the firm could repurchase its own stock and still earn.
Cost of Equity: Cost of retained earnings
• To determine the Cost of Retained Earnings, there are three ways:
• BOND YIELD PLUS RISK PREMIUM
• 𝑟𝑠 = 𝑟𝑑 + 𝑅𝑃
• Empirical studies suggest that the risk premium on a firm’s stock over its own bonds
generally ranges from 3 to 5 percentage points.
• CAPITAL ASSET PRICING METHOD (CAPM)
• 𝑟𝑠 = 𝑟𝐹𝑅 + 𝑏(𝑟𝑀 − 𝑟𝐹𝑅 )
• DISCOUNTED CASH FLOW APPROACH (DCF)
𝐷1
• 𝑟𝑠 = + 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑔
𝑃0
Cost of Equity: Cost of new common
stock
• Cost of New Common Stock:
• Issuance of new stock in order to raise funds.
• It is always higher than or equal to Cost of RE because of FC is
incurred and may depress stock price.
• Formula
• DISCOUNTED CASH FLOW APPROACH WITH FLOTATION COST
𝐷1
• 𝑟𝑒 = + 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑔
𝑃0 (1−𝐹%)
• There is Flotation cost since the issuance of new stocks involves indirect cost.
Illustration:
The future earning, dividends, and common stock price of BABOR
Technologies Inc. are expected to grow 7% per year. BABOR’s
common stock currently sells for $23.00 per share; its last dividend
was $2.00; and it will pay a $2.14 dividend at the end of the current
year.

a) Using the DCF approach, what is its cost of common equity?

b) If the firm’s beta is 1.6, the risk-free rate is 9% and the average
return on the market is 13%, what will be the firm’s cost of common
equity using the CAPM approach?