07-Mar-22

UNIVERSITY OF ECONOMICS – HO CHI MINH CITY

INCOME APPROACH

CONTENT

Capitalized Cash Flow (CCF)

Discounted Cash Flows (DCF)

Excess Cash Flow (ECF)

FUNDAMENTAL THEORY

✓Valuation principle:

“Value today always equals future cash flow discounted at the

opportunity cost of capital”

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FUNDAMENTAL THEORY

• The income approach is a mathematical fraction consisting of a numerator and

a denominator. The numerator represents the future payments of an investment,
and the denominator represents a quantification of the associated risk and
uncertainty of those future payments.

𝐸𝑖
𝑉= ෍
(1 + 𝑘𝑖 )𝑡

Ei : the future economic benefits of an investment in year i

ki: appropriate cost of capital

FUNDAMENTAL THEORY

Future economic benefit (Ei):

• Be an appropriate future benefit for the subject company being valued.

• Match the characteristics of the denominator. For example, if the numerator is
“after-tax cash flows to equity,” then the denominator must be an “after-tax cash
flow risk or discount rate to equity.”
• Be appropriate for the stakeholders defined.
Discounted Dividend Model → dividend streams:
Groups of stockholders
(both stockholders and bondholders; stockholders only; stockholders (Controlling,
non controlling, etc.)

FUNDAMENTAL THEORY

Discount rate (ki): The denominator, is the rate of return required for the
particular interest represented by the cash flow in the numerator. The
denominator reflects the opportunity cost, or the “cost of capital.”

The discount rate must reflect:

• The “real” rate of return—the amount investors expect to obtain in exchange for
letting someone else use their money on a riskless basis
• Expected inflation—the expected depreciation in purchasing power during the
period when the money is tied up
• Risk—the uncertainty as to when and how much cash flow or other economic
income will be received

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FUNDAMENTAL THEORY
simplifly discounted cf model
• Income approach methodologies:
• Capitalized Cash Flow - CCF constant growth model, gordon model , perpetual cf

• Discounted Cash flow - DCF multistage model

• Excess Cash Flow - ECF

The CCF method utilizes just one numerator and denominator, whereas the
DCF utilizes a series of fractions. The ECF method is really a hybrid method,
combining elements of both the asset and the income approaches.

why analyze in the past (historical statement) to predict future

The Income approach ề

Future economic benefits (Cash flows): usually estimated by using the

historical data and relevant information.
- Collect financial statements and related information (at least 5 years)
- Figure out if any information needed adjustments
- Conduct normalization if necessary

The Income approach

Normalization Process for valuation purpose: for forecast purpose

1. For ownership characteristics (control versus minority)

why controlling shareholder khác minority shareholder
2. For GAAP departures and extraordinary, nonrecurring, and/or unusual
items
- has different voting power ( control: has right to make decision>minority)
3. For nonoperating assets and liabilities and related income and expenses
4. For taxes
5. For synergies from mergers and acquisitions, if applicable

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Normalization for valuation purpose

1. Adjustments For Ownership Characteristics:

+ Controlling shareholders’ interests are different with Minority shareholders’

interest.
o No adjustment → Minority shareholders’ interest → value of M
o Adjusted for Controlling shareholders’ interest → value of C (add the benefits
that controlling shareholders enjoy)
Note: tax might be adjusted accordingly.

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- convert value of minority shareholders (Vm) to that of controlling shareholder(Vc)

Normalization for valuation purpose: there are 2 ways
+ if excess CFs control> minority (extra benefits can be quantified)
1. Adjustments For Ownership Characteristics:
CFc = CFm + Extra CFs
Other examples of common control adjustments include:
• Excess fringe benefits including healthcare and retirement Vc = Vm + Vextra
• Excess employee perquisites (premium
• Excess rental payments to shareholders
• Excess intercompany fees and payments to a commonly controlled sister company + if extra benefit cannot be quantified

• Payroll-related taxes Vc = Vm x (1 + % premium)

• Reimbursed expenses
• Nonbusiness travel and entertainment of shareholders and/or key individuals
ế
• Related-party transactions (i.e., leases between shareholder and entity)
• Sales/purchases to/from related entities
• Capital structure
• Excess or insufficient interest on loans to/from shareholders

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Normalization for valuation purpose

1. Adjustments For Ownership Characteristics:
• Example: Assume a control shareholder’s salary is in excess of market value by $300,000 per
year and the capitalized cash flow method is used to value the net cash flow of the company.
NCF $700.000 (on a non control basis). Capitalization rate (k-g) is 20%.

• Without adjustment: NCF = $700,000 → Value of M

700,000
𝑉𝑀 = = $3,500,000
0.2
• With adjustment: add back the excess salary into the company cash flows → value of C
NCFadj = 700,000 + 300,000 = $1,000,000
1,000,000
𝑉𝐶 = = $5,000,000
0.2
➔ Value of excess benefit: VEB= 300,000/15% = $2,000,000 → Vc = VM + VEB → premium=
➔ To get VM from Vc → apply a discount that reflect the C’s excess benefits → discount

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Normalization for valuation purpose

1. . Adjustments For Ownership Characteristics:

• EX: If the analyst chooses to make the control normalization adjustment, a

minority interest value still could be determined by utilizing a discount for lack of
control.

Adjust or not?

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Normalization for valuation purpose

2. Adjustments for GAAP departures and extraordinary, nonrecurring, and/or
unusual items
ỏ
• Purpose: to present a normal operating picture to project earnings into the
future.

• Analysts use historical data to estimate future benefits → must assure:

o consistent accounting standards and principles.
o removal of unusual, nonrecurring and extraordinary items

Note: Tax must be adjusted accordingly

100-> 100(1-tc)

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Normalization for valuation purpose

3. Adjustments for nonoperating assets and liabilities and related income
and expenses

Purpose: Valuation on the company’s core operations

➔ Use OCF, operating assets (both tangible and intangible), operating revenue and
expenses.
➔ Remove all non-operating assets from the balance sheet and Income statement.
• Note: Non-operating assets and liabilities are separatedly valued and added back
to the respective value as of the valuation date.

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Normalization for valuation purpose

4. Adjustment for taxes
Purpose: Identify the appropriate tax rate
Determining the tax on future income can incorporate the:
• Actual tax rate
• A: + Agriculture (0%) + RE (20%) → 100 + 900 – NI = 1000
• Highest marginal tax rate
• Average tax rate = Tax bill/Taxable earning

Which rate?

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Normalization for valuation purpose

4. Adjustment for taxes
EX: Company A has EBT = $1.000.000

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Normalization for valuation purpose

4. Adjustment for tax
• The tax issue becomes even more controversial when the entities involved are
pass-through entities such as S corporations and partnerships. Since these
entities have little or no federal and state tax liability, applying after-tax discount
and capitalization (“cap”) rates to pretax income would result in a higher value
for the passthrough entity, all other things being equal (see Exhibit 5.2).

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Normalization for valuation purpose

5. Adjustments for synergies from mergers and acquisitions

• Synergistic value is investment value, which may not be fair market value.
Synergistic adjustments may be needed in mergers and acquisitions
engagements. These adjustments will vary in complexity

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income(profit) NOPAT = EBIT x (1-tc)
ạ
ệ
cfs to minority shareholder

Future Economic
Cfs to equity
Benefit cfs to controlling shareholder
(direct method)

CFs Cfs invested capital (indir)

DETERMINATION OF FUTURE BENEFIT STREAM (CASH FLOWS)

Following CFs can be used:

• Net Income (Net operating income - NOP): Net income is the measure of an
entity’s operating performance.
NOP = Operating revenue – Operating expenses (direct and indirect)
- In many small company, income and cash flow can be the same or similar.
- NOP can be before or after tax → NOPAT
+ Advantage:
- Easy to get
+ Disadvantage: vì small company

- difficult to develop discount and cap rates relative to net income; cash flow
rates of return are more readily available using traditional cost of capital techniques.

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DETERMINATION OF FUTURE BENEFIT STREAM (CASH FLOWS)

• Net cash flow (NCF): NCF = CFin – CFout

• NCF is most often-used measure of future economic benefit because it
generally represents the cash that can be distributed to equity owners without
threatening or interfering with future operations.
• Net cash flow is akin to dividend-paying capacity and as such can be seen as
a proxy for return on investment. Finally, it is the measure on which most
commonly accepted empirical data on rates of return are based.

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DETERMINATION OF FUTURE BENEFIT STREAM (CASH FLOWS)

•Net cash flow (NCF): The benefit streams (NCF) are used in valuation model
depending on who the beneficiaries are:
(1) Cash Flow Direct to Equity → Direct equity method
+ Dividend cash flows
+ Cash flows to equity (FCFE)
(2) Cash Flow to Invested Capital→ Indirect method (invested capital method)
+ Cash flows to firm (FCFF)

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CFs to equity holder

- Dividends (cash dividend) -> disc dividend model
- Free CFs to equity holders : FCFE

DETERMINATION OF FUTURE BENEFIT STREAM (CASH FLOWS)

CFs to invested capital - FCFF
• Cash Flow Direct to Equity: ( CFs to investors ( Bondholders and shareholders ) )

•Dividend Cash Flows: → Cash dividend streams the company pays to

shareholders.

Dividends depend on dividend payout policy of the company.

profit margin
D = payout ratio * NI
TAT ..................->NI
Payout ratio = dividend per share / EPS

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DETERMINATION OF FUTURE BENEFIT STREAM (CASH FLOWS)

• Cash Flow Direct to Equity:

• Free Cash flow to equity (FCFE)

Net new debt raised

→ debt-inclusive method.
→ Requires an appropriate discount rate for this cash flow.

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FCFF = NI + NCC + I * (1-tc) - Capex - DNWC
= CFO + I * (1-tc) - Capex
= EBIT * (1-tc) + Dep - Capex - DNWC
=EBITDA * (1-tc) + Dep*tc - Capex - DNWC

FCFE = FCFF - I * (1-tc) + Net borrowings

= CFO - Capex + Net borrowings
FCFE = NI + NCC - Capex - DNWC + Net borrowings

DETERMINATION OF FUTURE BENEFIT STREAM (CASH FLOWS)

• Cash Flow Invested Capital –(FCFF):
Net income after tax (NOPAT)
+ interest expense (tax affected)
depreciation, amortization, and other noncash changes6.
-/+ incremental “debt-free” working capital needs (Change in Non debt NWC)
- incremental capital expenditure needs (Capex)
= net cash flow to invested capital (Cash Flow Invested Capital)

• In the other words:

FCFF = FCFE + interest expense* (1-tc%) + (retirement of outstanding debt
(principals) – proceeds from new debt issues)
→ Requires an appropriate discount rate for this cash flow.

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FCFE = NI + Dep – Change in NWC – Capex + New debt – Debt

repayment

a. FCFE2020 = 41.1 + 12.5 – (175 – 180) – 15 + 0 = $43.6

• FCFE2021 = 48 + 14 – ( 240– 175) – 18 + 0 = -$21

b. WC ratio = WC/Revenue = 175/544 = 32%

→WC2021= 32%*Revenue2021 = 32%*620 = $24

• FCFE2021 = 48 + 14 – ( 24 – 175) – 18 + 0 = $20

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application in excel
INCOME STATEMENT
Sales -> sales growth rate ->g + Projected sales = sales x (1+g)
t t-1
-historical performance

-economic environment value drivers

- management stategies

- peer action

USING HISTORICAL DATA TO DETERMINE FUTURE BENEFIT COGS = (COGS/SALES) x Projected Sales

STREAM (CASH FLOWS)

gross profit = projected sales - projected cogs
1. The current earnings method SG&A = (SG&A/SALES) x Projected Sales

• The current year’s income is sometimes the best proxy for the following year and Depreciation = (Depre/ Sales) x Projected sales

future years in many closely held companies. ệ

• If everything is unchanged, BOM can keep the future CFs constant or growing at
constant growth rate forever.
ạ
EBIT (NOI) = P. Sales - Costs - Dep
Int exp = Projected interest rate x Begin Debt balance
EBT = EBIT - Int
Tax= Marginal TR x EBT
NI = EBT - TAX
DIVIDEND = PAYOUT RATIO x NI or Par Value

ị
30 ộ

ề
ạ
Q1 10 ặ
Q2 10 ả
Q3 10

Q4 20

FORECASR 2025 =20 (CURRENT)

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USING HISTORICAL DATA TO DETERMINE FUTURE BENEFIT

STREAM (CASH FLOWS)
2. The simple average method
• The simple average method uses the arithmetic mean of the historical data during
the analysis period. (normally 5 years)
• EX: AEC Corporation
Year Normalized CFs ($)
2015 -5 100,000
2016 -4 90,000
2017 -3 160,000
2018 -2 170,000
2019 1 180,000
Trung bình 700,000/5 = $140,000 (simple average)

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USING HISTORICAL DATA TO DETERMINE FUTURE BENEFIT

STREAM (CASH FLOWS)

2. The simple average method

• Advantages:
- Simple and easy to calculate
• Disadvantages:
- It may not be a good indication of change in company’s growth rate or other
trend which is expected to continue.
• Application:
o In the case of stable CFs through years.
o Mostly used in CCF valuation method.

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USING HISTORICAL DATA TO DETERMINE FUTURE BENEFIT

STREAM (CASH FLOWS)

2. The weighted average method

When the historical financial information yields a discernible trend, a weighted
average method may yield a better indication of the future economic benefit
stream, since weighting provides greater flexibility in interpreting trends.
• Application:
o Historical data do not show a clear trend.
o greater weight be applied to the most recent operating periods.
o 0 weight can be applied if the value of that year is unusual.

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USING HISTORICAL DATA TO DETERMINE FUTURE BENEFIT

STREAM (CASH FLOWS)
2. The weighted average method
EX:

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USING HISTORICAL DATA TO DETERMINE FUTURE BENEFIT

STREAM (CASH FLOWS)
3. The weighted average method
Year Weight Normalized CFs($) Weighted Adjusted CFs ($)
2015 1 100,000 100,000x1
2016 2 90,000 90,000 x2
2017 3 160,000 160,000x3
2018 4 170,000 170,000 x4
2019 5 180,000 180,000x5
Weighted 15 700,000 = 2,340,000/15 =$156,000
average

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USING HISTORICAL DATA TO DETERMINE FUTURE BENEFIT

STREAM (CASH FLOWS)
3. The weighted average method
Year Weight Normalized CFs($) Weighted Adjusted CFs ($)

2015 0 100,000 100,000x0

2016 0 90,000 90,000 x0
2017 1 160,000 160,000x1
2018 2 170,000 170,000 x2
2019 3 180,000 180,000x3
Weighted 6 700,000/5 = $140,000 = 1,040,000/6 =$173,333
Average

If value of years of 2015 and 2016 are not appropriate for forecasting → 0 weight
can be applicable.

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USING HISTORICAL DATA TO DETERMINE

FUTURE BENEFIT STREAM (CASH FLOWS)

4. Trend line – static method

This method is applicable in the case of continuing trend line in the future.

where:
y: predicted value of y variable for selected x variable
a: y intercept (estimated value of y when x 0)
b: slope of line (average change in y for each amount of change in x)
x: independent variable

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USING HISTORICAL DATA TO DETERMINE FUTURE BENEFIT

STREAM (CASH FLOWS)

4. Trend line – static method

where:
X: value of independent variable
Y: value of dependent variable
N: number of items in sample
: mean of independent variable
: mean of dependent variable

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USING HISTORICAL DATA TO DETERMINE FUTURE BENEFIT

STREAM (CASH FLOWS)
4. Trend line – static method
EX: Historical CFs of ACE Corporation are as follows:
X Y XY X2
1 100,000 100,000 1
2 90,000 180,000 4
3 160,000 480,000 9
4 170,000 680,000 16
5 180,000 900,000 25
15 700,000 $2,340,000 55
Calculate b and a:
𝐍(σ 𝐗𝐘) − (σ 𝐗)(σ 𝐘) 𝟓 ∗ 𝟐, 𝟑𝟒𝟎, 𝟎𝟎𝟎 − 𝟏𝟓 ∗ 𝟕𝟎𝟎, 𝟎𝟎𝟎
𝐛= 𝟐 = = $𝟐𝟒, 𝟎𝟎𝟎
𝐍(σ 𝐗 𝟐 ) − (σ 𝐗) 𝟓 ∗ 𝟓𝟓 − 𝟏𝟓𝟐

σ 𝐘 𝐛 σ 𝐗 𝟕𝟎𝟎, 𝟎𝟎𝟎 𝟐𝟒, 𝟎𝟎𝟎 ∗ 𝟏𝟓

𝐚= − = − = $𝟔𝟖, 𝟎𝟎𝟎
𝐍 𝐍 𝟓 𝟓
• Y = $68,000 +24,000*5 = $188,000

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USING HISTORICAL DATA TO DETERMINE FUTURE BENEFIT

STREAM (CASH FLOWS)
5. Formal Projection Method (Detailed Cash Flow Projections)

• The formal projection method uses projections of cash flows or other economic
benefits for a specified number of future years (generally three to five) referred to
as the “explicit,” “discreet,” or “forecast” period.
• Using normalized historical balance sheet and Income statement
• Need further information from discussion with company BoM to verify what items
needed adjustments so that the forecasted value can exactly reflect the company’s
prospect.
• Mainly applicable for DCF method.
• Note: If using the FCFE or FCFF methods, it is necessary to forecast Capex, NWC,
depreciation, net new debt raised.

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USING HISTORICAL DATA TO DETERMINE FUTURE BENEFIT

STREAM (CASH FLOWS)
Excercise: Historical CFs of a company are as below:
Year Normalized income/CFs($)
2015 130.000
2016 140.000
2017 150.000
2018 160.000
2019 170.000
2020 180.000

Estimate the CFs of 2021, using the first 4 methods. Which should be the
most appropriate? Please explain.

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INCOME APPROACH VALUATION METHODS

The Capitalized Cash Flow method - CCF:

• The capitalized cash flow method (CCF) is an abbreviated version of the
discounted cash flow method where both growth (g) and the discount rate (k) are
assumed to remain constant into perpetuity.

PV: Present value

NCF1: Expected economic income in the full period immediately following the n
effective valuation date realized at the end of the period
k: Present value discount rate (i.e., the cost of capital)
g: Expected long-term growth rate into perpetuity
k-g: Capitalization rate

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INCOME APPROACH VALUATION METHODS

The capitalized cash flow method - CCF:
End-of-Year Convention for CCF:

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INCOME APPROACH VALUATION METHODS

The capitalized cash flow method - CCF:
Midyear Convention for CCF Method:
0.5
𝑁𝐶𝐹1 ∗ 1 + 𝑔
𝑃𝑉 =
𝑘−𝑔

PV: Present value

NCF1: Expected economic income in the full period immediately following the n
effective valuation date realized at the end of the period
k: Present value discount rate (i.e., the cost of capital)
g: Expected long-term growth rate into perpetuity
k-g: Capitalization rate

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INCOME APPROACH VALUATION METHODS

The capitalized cash flow method - CCF:

•EX: Kimberly-Clark, a household product manufacturer, reported earnings per share of $3.20 in
1993, and paid dividends per share of $1.70 in that year. The firm reported depreciation of $315
million in 1993, and capital expenditures of $475 million. (There were 160 million shares
outstanding, trading at $51 per share.) This ratio of capital expenditures to depreciation is
expected to be maintained in the long term. The working capital needs are negligible. Kimberly-
Clark had debt outstanding of $1.6 billion, and intends to maintain its current financing mix (of
debt and equity) to finance future investment needs. The firm is in steady state and earnings are
expected to grow 7% a year. The stock had a beta of 1.05. (The treasury bond rate is 6.25%.)
• A. Estimate the value per share, using the Dividend Discount Model.
• B. Estimate the value per share, using the FCFE Model.
•C. How would you explain the difference between the two models, and which one would you
use as your benchmark for comparison to the market price?

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INCOME APPROACH VALUATION METHODS

The capitalized cash flow method - CCF:
11 Common Mistakes:
1. Understating or overstating growth rates
2. Failure to convert to the capitalization rate
3. Failure to properly normalize earnings
4. Identifying control versus noncontrol cash flows
5. Using beginning rather than ending cash flows
6. Applying a discount rate inconsistent with estimated future cash flows
7. Not applying midyear convention
8. Not adding or properly adjusting for nonoperating assets.
9. Working capital deficiency
10. Non reconciliation of capital expenditures and depreciation
11. Using cash flows to equity over cash flows to invested capital (or vice versa).

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INCOME APPROACH VALUATION METHODS

The discounted cash flow method - DCF:

The basic model:

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INCOME APPROACH VALUATION METHODS

The Discounted Cash Flow method - DCF:

• The expansion model:

E1 E2 En
PV= + +…+ (1+k)n
(1+k)1 (1+k)2

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The Discounted Cash Flow method - DCF:

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End-of-Year and Midyear Conventions

End-of-Year Conventions

However, end-of-year convention is only applicable when valuation date is at

beginning or ending of forecasted period (e.g. 1 Jan. or 31/12)

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End-of-Year and Midyear Conventions

Midyear Convention

The midyear convention DCF model treats periodic cash flows as if they will be
received in the middle of the year. This is accomplished by starting the first
forecast period (n) at midperiod (.5n). Each successive forecast period is
calculated from midperiod to midperiod (.5n +1).

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Adjusting the DCF for a Specific Valuation Date

Assume:
NCF = $100,000 n =1
Cash flows have been distributed equally over fiscal year 2009
g = 7% ke = 20%

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Adjusting the DCF for a Specific Valuation Date

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Adjusting the DCF for a Specific Valuation Date

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Multistage Explicit Periods

It is possible to have more than one explicit period in a DCF calculation.

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Terminal Value

• The terminal value is the value of the business after the explicit or
forecast period. “Terminal value” is generally synonymous with
residual value, reversionary value, continuing value, and future value.
• Theterminal value is critically important as it often represents a
substantial portion of the total value of an entity.

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Terminal Value

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Terminal Value

• EX:

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Terminal Value

• Calculation of the Terminal Value

The most common model to estimate the Terminal Value is Gordon Growth
Model (GGM):

𝑁𝐶𝐹𝑛+1 𝑁𝐶𝐹𝑛 (1+𝑔)

𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 = =
𝑘−𝑔 𝑘−𝑔

• The growth rate (g) used to calculate the Terminal Value is normally assumed
the future average growth rate.

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Terminal Value

• Calculation of the Terminal value

Other model to estimate the Terminal Value:

➢ Exit Multiple Model

➢“H” Model
➢Value Driver Model - VDM
➢Advanced Growth Model – AGM

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Terminal Value
• Calculation of the Terminal value

Exit Multiple Model

• One alternative method for determining the amount of the terminal value is to use
a multiplier of an income parameter such as net income, earnings before interest
and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization
(EBITDA), etc.
• TV = the latest 12-month multiples x Projected statistic
- This multiple, which is often used by investment bankers, is generally determined
from guideline company market data and is referred to as an “exit multiple.”
- It is not as popular as GGM, but it can be used effectively as a reasonableness
check on other models

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Terminal Value
• Calculation of the Terminal value

“H” Model
• The “H” Model assumes that growth during the terminal period starts at a
higher rate and declines in a linear manner over a specified transition period
toward a stable growth rate that can be used into perpetuity.

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Terminal Value
• Calculation of the Terminal value
H” Model
• The “H” Model calculates a terminal value in two stages.
• The first stage quantifies value attributable to extraordinary growth of the
company during the forecast period.
• The second stage assumes stable growth and uses a traditional Gordon
Growth formula

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Terminal Value
• Calculation of the Terminal value

➢ Value Driver Model - VDR

• VDR discounts or capitalizes the adjusted net income of the company directly
by the cost of capital.
- Advantages:
o do
not have to estimate the level of incremental investment of the entity.
o Eliminates theuncertainty surrounding the estimation of perpetual growth that is a
major influence on the value using the Gordon Growth Model

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Terminal Value
• Calculation of the Terminal value

Value Driver Model - VDR

Assumption:: ROIC converges to WACC, regardless of the company’s growth rate

- The basic formula:

- NOPLAT: Net operating profit less applicable taxes

NOPLAT = EBIT*(1-T)
- WACC: Weighted average cost of capital
- T+1: First year after explicit forecast period

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Terminal Value
• Calculation of the Terminal value

Value Driver Model - VDR

Assumption:: ROIC converges to WACC, regardless of the company’s growth rate

- The expanded formula:

- NOPLAT: Normalized level of NOPLAT in the first year after explicit forecast period
NOPLAT = EBIT*(1-T)
- g: Expected growth rate in NOPLAT in perpetuity
- ROIC: Expected rate of return on net new investment.

When ROIC is equal to the WACC, then the formular is converged to the basic one.

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Terminal Value
• Calculation of the Terminal value
Value Driver Model - VDR
In some cases, VDM is used to to test the implicit return on net new investment (ROIC) that is
within the Gordon Growth Model

Note: The VDM can

result in a lower
terminal value than
the
GGM.

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Terminal Value
• Calculation of the Terminal value
Advanced Value Driver Model - AGM
• Developed by Mike Adhikari, owner of Illinois Corporate Investments, Inc., and Business
ValueXpress.
• In essence, an expansion of the GGM.

- The expanded formula:

- NOPLAT: Normalized level of NOPLAT in the first year after explicit forecast period
NOPLAT = EBIT*(1-T)
- g: Expected growth rate in NOPLAT in perpetuity
- ROIC: Expected rate of return on net new investment.

When ROIC is equal to the WACC, then the formular is converged to the basic one.

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Terminal Value
• Calculation of the Terminal value
Advanced Value Driver Model - AGM

• Developed by Mike Adhikari, owner of Illinois Corporate Investments, Inc., and

Business ValueXpress.
• In essence, an expansion of the GGM.
• The AGM will adjust the terminal value for changes in capital structure, whereas
the GGM does not.
→ AGM splits the enterprise’s cash flow to debt holders from cash flow to equity
holders (CF-Eq).
→ AGM terminal value will be lower than if determined by the GGM, other things
being equal.

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Terminal Value
• Calculation of the Terminal value

Advanced Value Driver Model

- AGM
AGM’s assumptions:
• Debt payments have priority over dividends.
• CF-Eq, which is the excess cash flow to equity
after debt service and after funding working
capital and capital expenditure, is distributed.
• EBITDA, depreciation, capital expenditures,
and increases in working capital are a fixed
percentage of sales.
• The debt service will be serviced by the
business or, in the event of a shortfall, the
owners.
• The enterprise is sold or revalued at the end of
the holding period (n), which needs to be less
than the debt amortization period (p).

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INCOME APPROACH VALUATION METHODS

The discounted cash flow method (DCF) – Further discussion:
CCF is the abbreviation version of the DCF, where g and k are assumed to remain constant into
perpetuity

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INCOME APPROACH VALUATION METHODS

Excess Cash Flow Method – ECF
• Excess Cash Flow Method (other names: “excess earnings method”, the “Treasury method,” and
the “formula method,” is a blend of the asset and income approaches
This method has become popular in:
• valuing businesses for divorce cases, especially in jurisdictions where goodwill is considered a
nonmarital asset and is therefore segregated.
• Sometimes valuing businesses for corporate C to S conversions, financial reporting and other
scenarios where there is a need to isolate certain intangible assets.
• determining the fair market value of intangible assets of a business only if there is no better basis
available for making the determination” (emphasis added).

The ECF method can be prepared using either equity or invested capital returns and cash
flows.

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Excess Cash Flow Method – ECF

Procedures for ECF

Note: The return on

intangible assets is,
indeed, a discount
rate, which
represents a
capitalization rate
that incorporates
such growth.

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Step 1: Determine the Fair Market Value of Net Tangible Assets

• Net tangible assets: (not including intangible assets)

✓ all current assets
✓ plant, property, and equipment
• other operating assets less current liabilities (debt-free for invested capital
method)
In which:
✓ Cash, receivables, inventory→ can use book value as proxy of FMV
✓ PPE: → require independent appraisal because of difference between BV and
FMV.
✓ all intangible assets are excluded from “net tangible assets.
Ex: FMV of net tangible asset is $40.000.000

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Step 2. Develop “Normalized” Cash Flow

• ECF requires adjustments to get “normalized CFs” (or income in many cases).
• The ECF method yields a control value.
• Control-related adjustments as well as the other normalizing adjustments must
be made to the benefit stream to get minority value.
•These adjustments include normalization of owner’s compensation.
Ex: Normalized Cash flow is $40.000.000

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Step 3. Determine an Appropriate Blended Rate for Net Tangible Assets

• The rate of return for net tangible assets is based on the company’s bundle of assets.
• The company’s ability to borrow against this bundle.
• The company’s cost of debt, and its cost of equity are the other factors used in
developing a rate of return on net tangible assets .
• Historical industry rates of return may not be a good representation of what will occur
in the future even is commonly used by some analysts. It is preferable, particularly for
smaller companies, to build up a rate of return using the risk-free rate, large- and
small-company equity risk premiums, and the company’s specific risk factors.

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EX: Estimating rate

of return for net
tangible assets

Assumption:
▪ Tax rate: 35%
▪ ROE: 25%
▪ After tax interest
rate
= 9%*(1- 35%)=5.9%

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Step 4: Determine the Normalized Cash Flows Attributable to Net Tangible

Assets

• The cash flows attributable to net tangible assets would be equal to the sum of the
FMVs of those assets times the blended rate for the bundle of assets.
• EX:

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Step 5. Subtract Cash Flows Attributable to Net Tangible Assets from Total
Cash Flows to Determine Cash Flows Attributable to Intangible Assets
CFs of intangible assets = Total CFs – CFs of tangible assets

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Step 6. Determine an Appropriate Rate of Return for Intangible Assets

• The sum of the individual

weighted average returns on
assets (including net working
capital) equals the weighted
average cost of capital for the
entity.
• The more liquid and secure the
assets, the lower the return that
is required. Therefore, goodwill
and other intangibles require
higher returns.
• EX: the required rate of returns
for intangible assets in this
example is 30%

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Step 7. Determine the FMV of the Intangible Assets by Capitalizing the Cash
Flows Attributable to Them by an Appropriate Capitalization Rate

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Step 8. Add Back the Fair Market Value of the Net Tangible Assets

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Step 9. Subtract Any Interest-Bearing Debt

• Value of equity catpial = Value of invested capital – Interest Bearing Debt

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Step 10. Reasonableness Test

• As can be seen from the calculation, the overall rate of return is 19.6 percent.
This appears to be a reasonable capitalization rate on invested capital.

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