Free Cash Flow (FCF)

Free Cash Flow (FCF) is a measure of how much cash a company

generates after accounting for the required working capital and capital

expenditures (CAPEX) of the company. It is a measurement of

a company’s financial performance and health. The more FCF a company

have, the better it is. It is a financial term which truly determines that

what is exactly available to distribute among security holders of the

company. So, FCF can be a tremendously useful measure for

understanding the true profitability of any business. FCF is nothing but a

portion of cash remains in the hands of a company after paying all its

capital expenditures like purchasing new machinery, equipment, land &

building etc. and satisfying all its working capital needs like accounts

payables. FCF is calculated from the Cash Flow Statement of the

company. most of the projects are selected on the basis of their timing

of cash inflows and outflows rather than its Net Income

Free cash Flow Formula

Below is the simple Free Cash Flow Formula

=Operating Cash Flow−Capital Expenditures

Step 1 – Cash Flow From Operations
Cash Flow from Operations is the sum total of Net Income and non-cash

expenses like Depreciation and Amortization. In addition, we add the

changes in working capital. Please note this change in the working

capital could be positive or negative.

Therefore, cash flow from Operations = Net Income + Non Cash

Expenses +(-) Changes in working capital

Step 2 – Find the Non Cash Expense

Noncash expense includes depreciation and amortization. Here in the

income statement, we have only depreciation figures provided. We will

assume that amortization is zero.

Step 3 – Calculate Changes in working capital

We see from above, changes in working capital = Accounts receivables

(2007) – Accounts receivables (2008) + Inventory (2007) – Inventory

(2008) + Accounts Payable (2008) – Accounts Payable (2007)

Step 4 – Find out the Capital Expenditure

Since we are not provided with the cash flow statement, we will use the

balance sheet and the income statement to derive these figures

Step 5 – Combine all the above components in FCF Formula
We can combine the individual elements to find a long FCF Formula and

caculate Free Cash Flow. The FCF Formula is equal to

Net Income + Depreciation and Amortization +(-) Accounts receivables

(2007) – Accounts receivables (2008) + Inventory (2007) – Inventory

(2008) + Accounts Payable (2008) – Accounts Payable (2007) – (Net PPE

2008 – Net PPE 2007 + Depreciation and Amortization)

Types of Free Cash Flow

1 – Free Cash Flow to the Firm (FCFF)
FCFF simply means the ability of the business to generate cash netting of

all its capital expenditures

= Operating Cash Flow−Capital Expenditures

2 – FCFE (EQUITY)
FCFE is a cash flow available for equity shareholders of the company. The

amount shows how much cash can be distributed to the equity

shareholders of the company as dividends or stock buybacks after all

expenses, reinvestments, and debt repayments are taken care of.

=FCFFB+ NET BORROWINGS – INTEREST * (1-TAX)

Significance of FCF
Free cash flow is important because it allows a company to pursue
opportunities that enhance shareholder value. Without cash, it's tough to
develop new products, make acquisitions, pay dividends and reduce
debt.
Some investors prefer using free cash flow instead of net income to
measure a company's financial performance, because free cash flow is
more difficult to manipulate than net income.
It is important to note that negative free cash flow is not bad in itself; on
the face of it. If free cash flow is negative, it could be a sign that a
company is making large investments. If these investments earn a high
return, the strategy has the potential to pay off in the long run.

Limitations of FCF
By their nature, expenditures for capital assets that will last decades
may be infrequent, but costly when they occur. Hence 'Free cash flow',
in turn, will be very different from year to year.
Investors must therefore keep an eye on companies with high levels of
FCF to see if these companies are under-reporting capital expenditure
and R&D.
Companies can also temporarily boost FCF by stretching out their
payments, tightening payment collection policies and depleting
inventories. And hence look for companies generating FCF on
sustainable basis.

Discounted cash flow (DCF) is a valuation method used to estimate

the value of an investment based on its future cash flows. DCF analysis
finds the present value of expected future cash flows using a discount
rate. A present value estimate is then used to evaluate a potential
investment. If the value calculated through DCF is higher than the
current cost of the investment, the opportunity should be considered.
 Meaning of Cost of Capital:
An investor provides long-term funds (i.e., Equity shares, Preference

Shares, Retained earnings, Debentures etc.) to a company and quite

naturally he expects a good return on his investment.

In order to satisfy the investor’s expectations the company should be

able to earn enough revenue.

Thus, to the company, the cost of capital is the minimum rate of return

that the company must earn on its investments to fulfill the expectations

of the investors.

Significance of Cost of Capital:

1. Maximisation of the Value of the Firm:

For the purpose of maximisation of value of the firm, a firm tries to

minimise the average cost of capital. There should be judicious mix of

debt and equity in the capital structure of a firm so that the business

does not to bear undue financial risk.

2. Capital Budgeting Decisions:

Proper estimate of cost of capital is important for a firm in taking capital

budgeting decisions. Generally cost of capital is the discount rate used in

evaluating the desirability of the investment project. In the internal

rate of return method, the project will be accepted if it has a
rate of return greater than the cost of capital.
3. Decisions Regarding Leasing:

Estimation of cost of capital is necessary in taking leasing decisions of

business concern.

4. Management of Working Capital:

In management of working capital the cost of capital may be used to

calculate the cost of carrying investment in receivables and to evaluate

alternative policies regarding receivables. It is also used in inventory

management also.

5. Dividend Decisions:

Cost of capital is significant factor in taking dividend decisions. The

dividend policy of a firm should be formulated according to the nature of

the firm— whether it is a growth firm, normal firm or declining firm.

However, the nature of the firm is determined by comparing the internal

rate of return (r) and the cost of capital (k) i.e., r > k, r = k, or r < k which

indicate growth firm, normal firm and decline firm, respectively.

6. Determination of Capital Structure:

Cost of capital influences the capital structure of a firm. In designing

optimum capital structure that is the proportion of debt and equity, The

objective of the firm should be to choose such a mix of debt and equity so

that the overall cost of capital is minimised.

7. Evaluation of Financial Performance :The concept of cost of capital

can be used to evaluate the financial performance of top management.

This can be done by comparing the actual profitability of the investment

project undertaken by the firm with the overall cost of capital.

Measurement /COMPONENTS of Cost of Capital:

A. Cost of Debentures:

The capital structure of a firm normally includes the debt capital. Debt

may be in the form of debentures bonds, term loans from financial

institutions and banks etc. The amount of interest payable for issuing

debenture is considered to be the cost of debenture or debt capital

B. Cost of Preference Share Capital:

For preference shares, the dividend rate can be considered as its cost,

since it is this amount which the company wants to pay against the

preference shares. Like debentures, the issue expenses or the

discount/premium on issue/redemption are also to be taken into

account.

C. Cost of Equity or Ordinary Shares:

The funds required for a project may be raised by the issue of equity

shares which are of permanent nature. These funds need not be

repayable during the lifetime of the organisation. Calculation of the cost

of equity shares is complicated because, unlike debt and preference

shares, there is no fixed rate of interest or dividend payment. Cost of

equity share is calculated by considering the earnings of the company,

market value of the shares, dividend per share and the growth rate of

dividend or earnings.

D. Cost of Retained Earnings:

The profits retained by a company for using in the expansion of the

business also entail cost. When earnings are retained in the business,

shareholders are forced to forego dividends. The dividends forgone by

the equity shareholders are, in fact, an opportunity cost. Thus retained

earnings involve opportunity cost.

Significance Of Cost Of Capital

1. Making Investment Decision

Cost of capital is used as discount factor in determining the net
present value. Similarly, the actual rate of return of a project is
compared with the cost of capital of the firm. Thus, the cost of
capital has a significant role in making investment decisions.

2. Designing Capital structure

The proportion of debt and equity is called capital structure. The
proportion which can minimize the cost of capital and maximize
the value of the firm is called optimal capital structure. Cost of
capital helps to design the capital structure considering the cost of
each sources of financing
3. Evaluating The Performance
Cost of capital is the benchmark of evaluating the performance of
different departments. The department is considered the best
which can provide the highest positive net present value to the
firm. The activities of different departments are expanded or
dropped out on the basis of their performance.
4. Formulating Dividend Policy
Out of the total profit of the firm, a certain portion is paid to
shareholders as dividend. However, the firm can retain all the
profit in the business if it has the opportunity of investing in such
projects which can provide higher rate of return in comparison of
cost of capital. On the other hand, all the profit can be distributed
as dividend if the firm has no opportunity investing the profit.
Therefore, cost of capital plays a key role formulating the
dividend policy.

5. Importance to Other Financial Decisions: Apart from the above

points, cost of capital is also used in some other areas such as, market

value of share, earning capacity of securities etc. hence, it plays a major

part in the financial management

Capital Rationing

Capital rationing is a strategy used by companies or investors

to limit the number of projects they take on at a time. If there
is a pool of available investments that are all expected to be
profitable, capital rationing helps the investor or business
owner choose the most profitable ones to pursue.

Companies that employ a capital rationing strategy typically

produce a relatively higher return on investment (ROI). This is
simply because the company invests its resources where it
identifies the highest profit potential

Capital Rationing Example

Capital rationing is about putting restrictions on investments and
projects taken on by a business. To illustrate this better, let’s consider the
following example:

VV Construction is looking at five possible projects to invest in, as shown

below ( profitability = NPV/INVESTMENT )

PROJECT INVESTMENT CAPITAL NET PRESENT VALUE PROFIT

A 2 LAKHS 2 1

B 4 4 1

C 5 3 0.6

D 4 2 0.5

E 6 5 0.83

Based on the table above, we can conclude that projects 1

and 2 offer the greatest potential profit. Therefore, VV
Construction will likely invest in those two projects.
Types of Capital Rationing

1. Hard capital rationing

Hard capital rationing represents rationing that is being
imposed on a company by circumstances beyond its control.
For example, a company may be restricted from borrowing
money to finance new projects because it has suffered a
downgrade in its credit rating. Thus, it may be difficult or
effectively impossible for the company to secure financing, or it
may only be able to do so at exorbitant interest rates.

2. Soft capital rationing

In contrast, soft capital rationing refers to a situation where a
company has freely chosen to impose some restrictions on its
capital expenditures, even though it may have the ability to
make much higher capital investments than it chooses to. The
company may choose from any of a number of methods for
imposing investment restrictions on itself. For example, it may
temporarily require that a project offer a a higher rate of return
than is usually required in order for the company to consider
pursuing it. Or the company may simply impose a limit on the
number of new projects that it will taken on during the next 12
months.

RISK
Systematic risk occurs due to macroeconomic factors. It is also
called market risk. it is beyond the control of a specific company
or individual All investments and securities suffer from such type
of risk. One can’t eliminate such a risk by holding more number of
shares Systematic risk impacts the entire industry rather than a
single company or security.
Unsystematic or “Specific Risk” are primarily the industry or
firm-specific risks that are there in every investment. Such risks
are also unpredictable and can occur at any time. Like, if workers
of a manufacturing company go on a strike resulting in the drop in
the stock price of that company.

INTEREST RATE RISK Such kind of risk is the result of a

change in the market interest rate. It mainly impacts the fixed
income securities as bond prices are inversely related to the
interest rate.

MARKET RISK It is the result of the general tendency of the

investors to move with the market. So, it is basically the
tendency of the security prices to move collectively. For
instance, in the falling market, the stock price of even the best
performing company’s drop.

PURCHASING POWER RISK Also called the Inflation Risk

occurs due to the erosion in the purchasing power of money.
Inflation is the rise in the general price level, meaning the same
amount of money buys fewer goods and services. So, if the
income of the investor fails to keep pace with the rising
inflation, then in real term, he is earning less than before

Liquidity Risk:This type of risk arises out of inability to execute

transactions. Liquidity risk can be classified into Asset Liquidity
Risk and Funding Liquidity Risk. Asset Liquidity risk arises eith
er due to insufficient buyers or insufficient sellers against sell or
ders and buy orders respectively.

Credit Risk:This type of risk arises when one fails to fulfill their
obligations towards their counter parties. Credit risk can be clas
sified into Sovereign Risk and Settlement Risk. Sovereign risk u
sually arises due to difficult foreign exchange policies. Settleme
nt risk on the other hand arises when one party makes the pay
ment while the other party fails to fulfill the obligations.

Operational Risk:This type of risk arises out of operational fail

ures such as mismanagement or technical failures. Operational
risk can be classified into Fraud Risk and Model Risk. Fraud ris
k arises due to lack of controls and Model risk arises due to inc
orrect model application.
The Capital Asset Pricing Model (CAPM) measures the risk
of a security in relation to the portfolio. It considers the
required rate of return of a security in the light of its
contribution to total portfolio risk.
Assumptions of Capital Asset Pricing Model
1. Risk-averse investors
The investors are basically risk averse and diversification is
necessary to reduce their risks.

2. Maximising the utility of terminal wealth

An investor aims at maximizing the utility of his wealth rather
than the wealth or return. Each increment of wealth is enjoyed
less than the last as each increment is less important in
satisfying the basic needs of the individual. Thus, the
diminishing marginal utility is most applicable to wealth.

3. Choice on the basis of risk and return:

Investors make investment decisions on the basis of risk and
return. Risk and return are measured by the variance and the
mean of the portfolio returns. CAPM assumes that the rational
investors put away their diversifiable risk, namely,
unsystematic risk. But only the systematic risk remains which
varies with the Beta of the security.

4. Similar expectations of risk and return

All investors have similar expectations of risk and return. In
other words, all investors’ estimates of risk and return are the
same. Varying preferences also imply that the price of an asset
will be different for different investors.

5. Identical time horizon

The CAPM is based on the assumption that all investors have
identical time horizon. The core of this assumption is that
investors buy all the assets in their portfolios at one point of
time and sell them at some undefined but common point in
future.

6. Free access to all available information

One of the important assumptions of the CAPM is that
investors have free access to all the available information at no
cost .if the available information has not reached all, it will be
difficult to draw a common efficient frontier line.

7. There are no taxes and transaction costs

According to Roll, there must be either a risk free asset or a
portfolio of short sold securities. Then only the capital Market
Line (CML) will be straight. When there are no risk free assets,
the investor could not create a proxy risk free asset. As a result,
the capital market line would not be linear and the direct linear
relationship between risk and return would not exist.

8. Total availability of assets is fixed and assets are marketable

and divisible
This assumption holds the view that the total asset quantity is
fixed and all assets are marketable. However, models have been
developed to include unmarketable assets which are more
complex than the basic CAPM.

Advantages of CAPM Model

Ease of Use
CAPM is a simple calculation that can be easily stress-tested to
derive a range of possible outcomes to provide confidence
around the required rates of return.

Diversified Portfolio
The assumption that investors hold a diversified portfolio,
similar to the market portfolio, eliminates unsystematic
(specific) risk.
Systematic Risk
CAPM takes into account systematic risk (beta), which is left
out of other return models, such as the dividend discount
model (DDM). Systematic or market risk is an important
variable because it is unforeseen and, for that reason, often
cannot be completely mitigated.

Business and Financial Risk Variability

When businesses investigate opportunities, if the business mix
and financing differ from the current business, then other
required return calculations, like the weighted average cost of
capital (WACC), cannot be used. However, CAPM can.

Disadvantages of CAPM Model

Risk-Free Rate (Rf)
The commonly accepted rate used as the Rf is the yield
on short-term government securities. The issue with using this
input is that the yield changes daily, creating volatility.

Return on the Market (Rm)

The return on the market can be described as the sum of
the capital gains and dividends for the market. A problem arises
when, at any given time, the market return can be negative. As
a result, a long-term market return is utilized to smooth the
return. Another issue is that these returns are backward-looking
and may not be representative of future market returns.

Ability to Borrow at a Risk-Free Rate

CAPM is built on four major assumptions, including one that
reflects an unrealistic real-world picture. This assumption—that
investors can borrow and lend at a risk-free rate—is
unattainable in reality. Individual investors are unable to borrow
(or lend) at the same rate

Determination of Project Proxy Beta

Businesses that use CAPM to assess an investment need to
find a beta reflective to the project or investment. Often, a proxy
beta is necessary. However, accurately determining one to
properly assess the project is difficult and can affect the
reliability of the outcome.

Capital Market Line (CML):

The Capital Market Line (CML) defines the relationship
between total risk and expected return for portfolios consisting
of the risk free asset and the market portfolio. If all the
investors hold the same risky portfolio, then in equilibrium it
must be the market portfolio. CML generates a line on which
efficient portfolios can lie.

Those which are not efficient will however lie below the line. It
is worth mentioning here that CAPM risk return relationship is
separate and distinct from risk return relationship of individual
securities as represented by CML. An individual security’s
expected return and systematic risk statistics should lie on the
CAPM but below the CML.

In contrast the risk less end (R) statistics of all portfolios, even
the inefficient ones should plot on the CAPM. The CML will
never include all points, if efficient portfolios, inefficient
portfolios and individual securities are placed together on one
graph. The individual assets and the inefficient portfolios
should plot as points below the CML because their total risk
includes diversifiable risk.

Security Market Line (SML):

Security Market Line describes the expected return of all assets
and portfolios of assets in the economy. The risk of any stock
can be divided into systematic risk and Unsystematic risk. Beta
(b) is the index of systematic risks. In case of portfolios
involving complete diversification, where the unsystematic risk
tends to zero, there is only systematic risk measured by Beta.

Thus, the dimensions of the security which concern us are

expected return and Beta. The expected return on any asset or
portfolio, whether it is efficient or not can be determined by
SML by focusing on Beta of securities. The higher the Beta for
any security the higher must be its equilibrium return.
E(Ri) =Rf + Bi (Rm-Rf)

E(Ri) = Expected rate of return on any individual security or

portfolio of securities.
Rf = Risk free rate of return

Rm = Expected rate of return on market portfolio

Bi = Market sensitivity index of individual security or portfolio

of securities.

Arbitrage Pricing Theory:

Like the CAPM, the Arbitrage Pricing Model is an equilibrium
model of asset pricing, but its origins are significantly different.
Whereas the CAPM is a single factor model, the APM is a multi-
factor model

Arbitrage pricing theory (APT) is a multi-factor asset pricing

model based on the idea that an asset's returns can be
predicted using the linear relationship between the asset’s
expected return and a number of macroeconomic variables that
capture systematic risk. It is a useful tool for analyzing
portfolios from a value investing perspective,

Assumptions :
(i) The investors have homogeneous beliefs/expectations

(ii) The investors are risk avert utility maximisers

(iii) The markets are perfect so that factors like transaction

costs are not relevant

(iv) The security returns are generated according to a factor

model.

(v) Risk-returns analysis is not the basis.

Single Factor Model:

According to this model the asset price depends on a single
factor, say Gross National Product or Industrial production or
interest rates, money supply, interest rates and so on.

In general, a single factor model can be represented in equation

form as follows:

R = E + bf + e

Where E = Uncertain return on security I

b = Security’s sensitivity to change in the factor

f = the actual return on the factor

e = error term (unexplained variable)

Thus, this model only states that the actual return on a security
equals the expected return plus sensitivity times factor
movement plus residual risk.
Multiple Factor Model:
Empirical work suggests that a number of variables should be
taken into account for asset pricing. The above mentioned
equation can, thus be expanded to:

R = E + b1f1 + b2f2 + b3f3 + …………. + e

Each of the middle terms in the equation is the product of
returns on a particular economic factor and the given stock’s
sensitivity to that factor.

But the basic question is what are these factors? They are the
underlying economic forces that are the primary influences on
the stock market. Several factors appear to have been identified
as being important. Some of these factors, such as inflation and
money supply, industrial production and personal consumption
do have aspects of being interrelated.

In particular, the researchers have identified the

following factors:-
i. Changes in the level of industrial production in the economy

ii. Changes in the shape of the yield curve

iii. Changes in the default-risk premium (i.e. changes in the

return required on bonds with different perceived risk of
default.)

iv. Changes in the inflation rate

v. Changes in the real interest rate

vi. The level of personal consumption

vii. The level of money supply in the economy

Risk and Expected Return

Intro of risk 1 pg
There is a positive relationship between the amount of risk
assumed and the amount of expected return. Greater the risk,
the larger the expected return and the larger the chances of
substantial loss.

Investments which carry low risks such as high grade bonds will
offer a lower expected rate of return than those which carry
high risk such as equity stock of a new company. A rational
investor would have some degree of risk aversion, he would
accept the risk only if he is adequately compensated for it.

One of the most difficult problems for an investor is to estimate

the highest level of risk he is able to assume

leverage means affect of one variable over another. In

financial management, leverage is not much different, it means
change in one element, results in change in profit. It implies,
making use of such asset or source of funds like debentures for
which the company has to pay fixed cost or financial charges, to
get more return. There are three measures of Leverage i.e.
operating leverage, financial leverage, and combined leverage.
 The operating leverage measures the effect of fixed cost
whereas the financial leverage evaluates the effect of interest
expenses. Combined Leverage is the combination of the two
leverages.

OPERATING BASIS FOR FINANCIAL

LEVERAGE COMPARISON LEVERAGE

Use of such assets in the Meaning Use of debt in a

company's operations for company's capital
which it has to pay fixed structure for which it has
costs is known as to pay interest expenses
Operating Leverage. is known as Financial
Leverage.

Effect of Fixed operating Measures Effect of Interest

costs. expenses

Sales and EBIT Relates EBIT and EPS

Company's Cost Ascertained by Company's Capital

Structure Structure

Low Preferable High, only when ROCE

is higher

DOL = Contribution / Formula DFL = EBIT / EBT

EBIT

It give rise to business Risk It give rise to financial

risk. risk.
Operating Leverage

When a firm utilizes fixed cost bearing assets, in its operational

activities in order to earn more revenue to cover its total costs is
known as Operating Leverage. The Degree of Operating
Leverage (DOL) is used to measure the effect on Earning before
interest and tax (EBIT) due to the change in Sales.

The firm, which employs high fixed cost and the low variable
cost is regarded as high operating leverage whereas the
company which has low fixed cost, and the high variable cost is
said to have less operating leverage. It is fully based on fixed
cost. So, the higher the fixed cost of the company the higher will
be the Break Even Point (BEP). In this way, the Margin of
Safety and Profits of the company will be low which reflects that
the business risk is higher. Therefore, low DOL is preferred
because it leads to low business risk.

The following formula is used to calculate Degree of Operating

Leverage (DOL):

Financial Leverage

The utilization of such sources of funds which carry fixed

financial charges in company’s financial structure, to earn more
return on investment is known as Financial Leverage. The
Degree of Financial Leverage (DFL) is used to measure the
effect on Earning Per Share (EPS) due to the change in firms
operating profit i.e. EBIT.

When a company uses debt funds in its capital structure having

fixed financial charges in the form of interest, it is said that the
firm employed financial leverage. The DFL is based on interest
and financial charges, if these costs are higher DFL will also be
higher which will ultimately give rise to the financial risk of the
company. If Return on Capital Employed > Return on debt,
then the use of debt financing will be justified because, in this
case, the DFL will be considered favorable for the company. As
the interest remains constant, a little increase in the EBIT of the
company will lead to a higher increase in the earnings of
the shareholders which is determined by the financial leverage.
Hence, high DFL is suitable.

The following formula is used to calculate Degree of Financial

Leverage (DFL):

all business valuation methods are ways to determine how

much your business is currently worth. The best valuation
approach typically depends upon why the valuation is needed,
the size of your business, your industry, and other factors

three business valuation methods are fairly standard

1. Market Value Business Valuation Method

A market value business valuation formula is perhaps the most

subjective approach to measuring a business’s worth: This
method reaches the value of your business by comparing it to
similar businesses that have sold. Of course, this business
valuation method only works for businesses that can access
sufficient market data on their competitors. It’ll be a particularly
challenging approach for sole proprietors, for instance, because
it’s difficult to find comparative data. You won’t have a public
database to go by. As this small business valuation approach
is relatively imprecise, your business’s worth will ultimately be
based on a negotiation, especially if you’re selling your
business or seeking an investor. You may be able to convince
a buyer of your business’s worth based on immeasurable
factors, but a savvy investor can see through that.

2. Asset-Based Business Valuation Methods

Next up are asset-based business valuation methods. As the

name suggests, these approaches consider your business’s
total net asset value, minus the value of its total liabilities,
according to your balance sheet.

There are two main ways to approach asset-based business

valuation methods:

Going Concern Businesses that plan to continue (i.e., not be

liquidated), and that none of its assets will be sold off
immediately, should use the going-concern approach to an
asset-based business valuation. This business valuation
formula takes into account the business’s current total equity
(or assets minus liabilities).

Liquidation Value On the other hand, the liquidation value

asset-based approach to business valuation is based on the
assumption that the business is finished and its assets will be
liquidated. The net amount is what would be realized if the
business is terminated and its assets sold off. The value of its
assets will likely be lower than usual, because liquidation value
often amounts to be much less than fair market value.

3. ROI-Based Business Valuation Method

Let’s take a look at ROI-based business valuation methods

from a very practical standpoint. When you’re considering
investing in something, what is your primary concern?
Probably, it’s your return on investment, or ROI. If you buy stock
in a company, you want a return. But what’s considered a
“good” ROI ultimately depends on the market, which is why
business valuation is so subjective.

1. Discounted Cash Flow (DCF): Also known as the income

approach, the DCF method values a business based on
its projected cash flow, adjusted (or discounted) to its
present value.
2. Capitalization of Earnings: This method calculates a
business’s future profitability based on its cash flow, annual
ROI, and its expected value. The Capitalization of
Earnings valuation method works best for stable
businesses, as the formula assume that calculations for a
single time period will continue.
3. Multiples of Earnings: Also known as the Times Revenue
Method, this formula calculates a business’s maximum
 worth by assigning a multiplier to its current revenue.
Multipliers vary according to industry, economic climate, and
other factors.
4. Book Value: Don’t forget about this business valuation
method, too, which we mentioned earlier. This business
valuation formula calculates the value of the business’s
equity (or total assets minus total liabilities), as per the
business’s balance sheet.

Advantages of Business Valuation

 Buying and Selling

It is known that companies tend to go through a business valuation if
they are selling their businesses. With a business valuation, the buyer
will know what is the maximum amount he/she should pay for the
business. For sellers, the business valuation will tell them the
minimum price they should be selling their enterprise.

 Dissolving Relationship
If a partner is looking to leave the company, business valuation will
give business owners a fair numerical value for him or her to be
bought out. The monetary worth of each stakeholder’s share in the
business will be identified through business valuation.

 Decision-Making Tool
Because valuation takes into account current market conditions, many
business owners use it as a decision-making tool. Business valuation
will help business owners identify the ‘perfect time’ to market their
business. If it is not the right time yet, they can hold out for a later
time when the market changes.
 Drive the Management
A routinary business valuation is a good regimen. It will gauge the
management’s performance and specify the facets of the business that
have to be changed or modified. More so, a business valuation will
enable the management to concentrate on important business matters

 Listed Entities
According to IESE Business School, the results of a business
valuation can be used to compare the value obtained with the share’s
price on the stock market and to decide whether to sell, buy, or hold
the shares. It can also be utilized as a tool in making comparisons
between entities

 Strategic Decisions and Planning

In furthering the business’ reach, business valuation serves as the
initial action in making resolutions on buying or selling companies,
growing, or merging with other entities. In addition, the valuation will
establish which commodities, goods, services, or clients must be kept,
developed, or dropped.

7. To Enhance the Performance of the Business

An annual valuation of the business may be used as a

benchmark to assess the performance of the business in its
execution of the corporate strategic plan. A series of annual
valuations provides objective information to shareholders so
that they may evaluate management and make appropriate
changes
8. To Manage Tax Transactions Efficiently

A well-documented business valuation is frequently an integral

component of effective tax planning strategies related to a
private business.
Planning of Capital Structure
Capital structure planning, which aims at the maximisation of
profits and the wealth of the shareholders, ensures the maximum
value of a firm or the minimum cost of the shareholders. It is very
important for the financial manager to determine the proper mix
of debt and equity for his firm. In principle every firm aims at
achieving the optimal capital structure but in practice it is very
difficult to design the optimal capital structure. The management
of a firm should try to reach as near as possible of the optimum
point of debt and equity mix.
Importance ----