CHAPTER 4 – INCOME – BASED VALUATION -cost of equity is higher than cost of debt, this is because

cost of equity is riskier as compared to the cost of debt

which is fixed.
INCOME BASED VALUATION
-cost of capital is a major driver in determining the equity
Income is based on the amount of money that the company value using income-based approaches.
or the assets will generate over the period of time. These
CAPITAL ASSET PRICING MODEL (CAPM)
amounts will be reduced by costs incurred to realize the
cash inflows and operate the assets.
CAPM = Risk free rate + Beta
Dividend Irrelevance Theory (Modigiliani and Miller) (Market Return – Risk free rate)
-supports the belief that stock prices are not affected by
dividends or the returns on the stock but more on the
ability and sustainability of the asset or company. -if there would be portion raised through debt, it should be
weighted accordingly to determine the reasonable cost of
Bird-in-the hand Theory (Myron Gordon and John
capital for the project to be used for discounting.
Linter)
-believes that dividend or capital gain has an impact on the COST OF DEBT
price of the stock.
-also known as the dividend relevance theory Cost of Debt = Risk free rate + Debt Margin

CERTAIN FACTORS THAT CAN BE CONSIDERED

ECONOMIC VALUE ADDED (EDA)
 EARNING ACCRETION – additional value
-most conventional way to determine the value of the asset.
inputted in the calculation that would account the
EVA is a convenient metric in evaluating investment as it
increase in value of the firm due to other
quickly measures the ability of the firm to support its cost
quantifiable attributes (potential growth, increase
of capital using its earnings.
in prices, and even operating efficiencies).
 EARNING DILUTION – this will reduce value if -EVA is the excess of company earnings after deducting the
there are future circumstances that will affect the cost of capital. The excess earnings shall be accumulated
firm negatively. for the firm.
 EQUITY CONTROL PREMIUM – is the
amount that is added to the value of the firm to GENERAL CONCEPT – the higher excess earnings is
gain control of it. better for the firm.
 PRECEDENT TRANSACTIONS – are previous Elements that must be considered in using EVA:
deals or experiences that can be similar with the
investment being evaluated. These transactions are  Reasonableness of earnings or returns.
considered risks that may affect further the ability  Appropriate cost of capital
to realize the projected earnings.
 KEY DRIVER – the cost of capital or the required EVA = Earnings – Cost of Capital
return for a venture. Cost of Capital = Investment Value x rate of
 COST OF CAPITAL CAN BE COMPUTED: Cost of Capital
 Weighted Average Cost
 Capital Asst Pricing Model
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
-can be used in determining the minimum required return.
It can be used to determine the appropriate cost of capital
by weighing the portion of the asset funded through
equity and debt.
-tax was considered in debt portion to factor in that the
interest incurred, or cost of debt is tax-deductible.
CAPITALIZATION OF EARNINGS METHOD

WACC = (Cost of Equity x Weight of the -the value of the company can also be associated with the
Equity Financing) + (Cost of debt after tax x anticipated returns or income earnings based on the
Weight of the debt Financing) historical earnings and expected earnings.
For green field investments – they will rely on its
projected earnings.
Earnings are typically interpreted as resulting from cash
flows from operations, but net income may also be used if
cash flow information is not available.
This method provides for the relationship of the:
1. Estimated earnings of the company
2. Expected yield / Required rate of return.
3. Estimated Equity Value

Equity Value = Future Earnings / Required Return

In case there are idle assets, this will be an addition to the

calculated capitalized earnings (equity value)
Capitalized earnings only represent the assets that
actually generates income or earnings and do not include
value of the idle assets.
LIMITATIONS
1. This does not fully account for the future earnings
or cash flows thereby resulting to over or
undervaluation.
2. inability to incorporate contingencies.
3. Assumptions used to determine the cashflows may
not hold true since the projections are based on a
limited time horizon.

-if earnings are fixed in the future, the capitalization

rate will be applied directly to the projected fixed
earnings.

-if the scenario is that future earnings are not

constant and vary every year, the approach is to
determine average of earnings of all the anticipated
cash flows.

DISCOUNTED CASH FLOW METHOD (DCF)

-the most popular method of determining the value.
-most sophisticated approach in determining the
corporate value. As it is more verifiable since this
allows for a more detailed approach in valuation.

DCF MODEL – calculates the equity value by

determining the present value of the projected net
cash flows of the firm.

The net cash flows may also assume a terminal value

that would serve as a representative value for the cash
flows beyond the projection.