The Practical Application of Discounted Cash-Flow Based Valuation Methods

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THE PRACTICAL APPLICATION OF DISCOUNTED CASH-FLOW BASED VALUATION METHODS Publication: Studia Universitatis Babes Bolyai – Oeconomica, LII, 2/2007 Author Name: Takács, András; Language: English Subject: Economy Issue: 2/2007 Page Range: 13-28 Summary: Valuation methods based on Discounted Cash-Flow (DCF) play a major role in the field of company valuation. The current literature contains a reasonably deep and detailed theoretical basis for DCFbased valuation, although, when starting to apply the techniques to evaluate a real company, some practical problems may appear. This study summarizes the most important practical difficulties which may hinder the valuation process and proposes different ways of solving these. Beyond the
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The calculation of FCF can be done according to the formula shown by Figure 1 (based on [Copeland, Murrin and Koller, 2000], [Fernandez, 2002] and [Agar, 2005]). Initially, we need to determine Earnings Before Interest and Tax (EBIT), which represents hypothetical earnings before tax which ignores the effect of interests paid on debt. It can be calculated as the reported earnings before tax plus the interest expense stated in the income statement [Bodie, Kane and Marcus, 2004]. The EBIT should then be reduced by the hypothetical tax (computed as EBIT * tax rate) in order to obtain Earnings After Tax without the effect of debt financing. This number shows the accounting profit which would have been realized had the firm used no debt to finance its operation.

1

According to [Fernandez, 2002], the most important types of cash-flow are the Free cashflow (cash-flow available to satisfy both the shareholders’ and creditors’ return requirements), the Equity Cash-flow (cash-flow available for shareholders) and the Debt Cash-flow (cash-flow available for creditors). 14

Earnings Before Interest and Tax (EBIT) – Tax on EBIT (EBIT * Tax rate)

Accounting earnings

= Earnings After Tax without debt

+ Depreciation expense – Increase in gross fixed assets – Increase in Working Capital

Adjusting items

= FREE CASH FLOW (FCF)
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