Question

In the context of recent research on the Weighted Average Cost of Capital (WACC), the Adjusted Present Value (APV) and the Flow-to-Equity (FTE), which of these methods would you use for the following companies (explain your choice).

A firm with uncertain growth rates for the next 10 years.

Answer 1

For a firm with uncertain growth rates for the next 10 years I will use flow-to-equity (FTE) method. In the FTE method we can compute the free cash flow to equity after incorporating or modeling the uncertainty in growth rates. We know that free cash flow to equity = net income – (capital expenditure – depreciation) – (changes in non-cash working capital) + (new debt issued – debt repayments)

Now we know that high-growth firms will have high net capital expenditure levels relative to its earnings level and low-growth firms will have low high net capital expenditure levels relative to its earnings. The growth rate in case of a firm with uncertain growth rates will also remain uncertain for its capital expenditure. Besides growth rate of net income, changes in new debt issued etc. will also remain uncertain.

In the wake of these uncertainties the FTE method can be adjusted to incorporate the uncertainties with regards to growth in income from a firm’s operating assets. The uncertainty factor can be built in or can be incorporated in the projections. We know that expected growth rate = retention ratio * return on equity. We can assume that retention ratio to remain stable while the return on equity will change as per the growth rate.

The projections and the valuation model will thus take into account the uncertainty factor and the resulting value will have the number which has been adjusted for uncertainty in an optimal manner.