Question

With regards to the DCF valuation:

a) What is the circularity issue in WACC calculation?

b) What is the circularity issue in APV in M&A case with debt capacity spillover.

Answer 1

A. Discounted Cash Flow model is used for the business valuation. This model uses the weighted average cost of capital which helps in discounting the expected returns to their present value. WACC is a methodology of Capital Asset Pricing Model that can be calculated by taking the weighted average of a firm's cost of debt and cost of equity.

Cost of equity can be explained through the following formula:

Ke = Rf + b *( Rm) where

Ke = Cost of equity

Rf = risk free rate

b = Beta

Rm = Market Return

The DCF valuation depends upon the fair market value of the stock. If the stock trades above the fair market value than it tends to be overvalued and if the stock trades below the fair market value than it tends to be undervalued. Undervalued stock are better according the the valuation.the DCF Valuation provides growth rate justifiable by the operating performance of the company.

B. APV is the Adjusted Present value. This is the method for the business valuation by aggregating the value of the firm with the intrest tax shields, sunsidies, costs of financial distress etc. APV Method generates more accurate results than WACC. APV can be used in all situations while WACC cannot.

APV and WACC are two methodology of DCF Model.Both methods are same but in most cases APV method is more favourable than WACC. WACC is used to discount the unlevered free cash flows with the after tax WACC whereas Apv method determines the levered value of an investment.