The enterprise-DCF model or FCFF model, discounts the expected cash flows available to equity, debt and other nonequity holders at the weighted average cost of capital (WACC), the blended cost of capital for all the capital provided by investors, to arrive at the value of operations of the company (Koller et al., 2015). FCFF is then computed as:
where NOPLAT = net operating profit less adjusted taxes
Invested Capital = total investor capital necessary to fund operations
Furthermore, the model assumes the company will maintain a stable debt-to-value ratio going forward. The value of operations of the company will then be equal to the sum of the present value of FCFF during and after the explicit forecast period. The latter component corresponds to the CV discounted to today.
Therefore, the value of operations can be written as:
2.1.2 Economic Profit
EP focuses on whether a company is earning its cost of capital and is able to quantify how much value is created each year. One disadvantage of enterprise-DCF is the fact that each year’s cash flows provide little knowledge about the company’s competitive position and economic performance. Koller et al. (2015) suggest the following measures of EP and ROIC:
where ROIC = return on invested capital
Similar to enterprise-DCF, EP also discounts economic profits at the WACC. Herewith, the restriction of a stable capital structure must be applied. Furthermore, if the company is expected to keep operating in the future, CV must be considered, such that:
The operating value of a company is equal to the book value of invested capital plus the present value of all future value generated.
2.1.3 Adjusted Present Value
When the debt-to-value ratio of a company is expected to change, the implementation of WACC-based models is more difficult (Koller et al., 2015). Berk and DeMarzo (2017) provide the following formula:
where = value levered
= value unlevered
ITS = interest tax shields
PV = present value
The value of the firm is, therefore, the value of future FCFF as if the company had no leverage plus the net value generated from the use of debt. The model divides the value of the firm into three components. The first values the company as if it were all-equity financed by discounting future FCFF at the unlevered cost of equity. Second, the value of expected interest tax shields that emerge from debt financing must be accounted. These arise from the fact that debt can be a source of value since interest payments can be deductible for tax purposes in most legislations worldwide. Third, the present value of financial distress costs, such as legal and administrative costs of bankruptcy, must be estimated by multiplying the company’s probability of default by the present value of bankruptcy costs.
Different opinions emerge regarding this model. On the one hand, Luehrman (1997) argues that the model makes it easier to deal with complex situations, such as changing debt structures, and gives a full overview on value creation by pinpointing the sources of value, such as reduction of costs, operating synergies, growth and tax savings. On the other hand, Booth (2002) advocates that APV is “frequently unreliable and should only be used in conjunction with more conventional valuation frameworks” and restricts its use for “structured financing, leveraged buyouts, project financing and real estate financing”.