CH. 8 PROSPECTIVE ANALYSIS: VALUATION IMPLEMENTATION

Computing a Discount Rate Weighted average cost of capital (WACC): weighting the costs of debt and equity capital according to their respective market values Market value for debt: use book value Market value of equity: “insert” target ratios of debt to capital and equity to capital. Estimating the cost of debt: interest rate on the debt (net-of-tax) Estimating the cost of equity: use Capital Asset Pricing Model (CAPM)

Terminal Values Remain constant Grow at the assumed sales growth rate Using multiple Selecting terminal years: usually 5-10 year forecast horizon

Dealing with Accounting Distortions Self correcting nature of double-entry bookkeeping, estimated values will not be affected by accounting choices, as long as the analysts recognizes the accounting distortions

Dealing with Negative Book Values Makes it difficult to use the accounting-based approach to value a firm’s equity Approach to handle this problem: Value the firm’s assets rather than equity “Undo” accountants’ conservatism by capitalizing the investment expenditures written off Start from the observed stock and work backwards