Question

Discounted Cash Flow Models discussed:

1. The Adjusted Present Value Model
2. The Free Cash Flow to Equity Model

What are the advantages and shortcomings of each?

Which one do you think is generally better to use? Why?

Answer 1

The adjusted present value model is used for valuation when a given firm has changing capital structure. The APV works like a Discounted cash flow model where the NPV of the firm is calculated presuming it is fully equity financed. Later advantage due to debt financing in the form of a tax shield is added back to the NPV of the firm. The APV model separates the value of the company into two components, The value of the operations as if the company was all equity financed and the value of tax shields, which comes due to debt in the capital structure. The APV approach is more advantageous for valuation during leveraged buyouts.

The free cash flow to equity method is one of the components used to value a firm by the discounted cash flow approach. This cash flow is available to the equity owners of the firm and is the net cash flow derived after adjusting operating expenses and capital expenditures. Debt holders expenses are adjusted before calculating FCFE. The FCFE approach states that the value of equity is equal to the forecasted stream of FCFE, which is discounted by the cost of equity, k_e . This approach is useful in valuing the total equity of the firm.