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19.98%
18.52%
18.52%
Cost of Debt
10.00%
10.00%
10.00%
10.00%
10.00%
10.00%
9.40%
9.25%
9.00%
8.50%
7.00%
7.00%
After-tax cost of debt
10.00%
10.00%
10.00%
6.61%
6.15%
6.15%
5.78%
5.69%
5.54%
5.23%
4.31%
4.31%
Cost of Capital
25.82%
25.82%
25.82%
25.82%
25.82%
25.82%
23.61%
22.04%
20.38%
18.50%
15.67%
15.67%
Cumulative WACC

1.2582
1.5830
1.9917
2.5059
3.1528
3.8973
4.7561
5.7252
6.7845
7.8479

Present Value of FCFF

-$10,897
-$21,174
-$36,438
-$45,395
-$55,515
-$54,706
-$32,273
$14,979
$39,062
$61,564


The Survival Issue
Implicit in the use of a terminal value in discounted cash flow valuation is the assumption that the value of a firm comes from it being a going concern with a perpetual life. For many risky firms, there is the very real possibility that they might not be in existence in 5 or 10 years, with volatile earnings and shifting technology. Should the valuation reflect this chance of failure and if so, how can the likelihood that a firm will not survive be built into a valuation?
Life Cycle and Firm Survival
There is a link between where a firm is in the life cycle and survival. Young firms with negative earnings and cash flows can run into serious cash flow problems and end up being acquired by firms with more resources at bargain basement prices. Why are new technology firms more exposed to this problem? The negative cash flows from operations, when combined with significant reinvestment needs, can result in rapid depletion of cash reserves. When financial markets are accessible and additional equity can be raised at will; raising more funds to meet these funding needs is not a problem. However, when stock prices drop and access to markets becomes more limited, these firms can be in trouble.
A widely used measure of the potential for a cash flow problem for firms with negative earnings is the cash-burn ratio, which is estimated as the cash balance of the firm divided by its earnings before interest, taxes and depreciation (EBITDA).
Cash Burn Ratio = Cash Balance / EBITDA
Thus, a firm with a cash balance of $ 1 billion and EBITDA of -$1.5 billion will burn through its cash balance in 8 months.
Likelihood of Failure and Valuation
` One view of survival is that the expected cash flows that you use in a valuation reflect cash flows under a wide range of scenarios from very good to abysmal and the probabilities of the scenarios occurring. Thus, the expected value already has built into it the likelihood that the firm will not survive. Any market risk associated with survival or failure is assumed to be incorporated into the cost of capital. Firms with a high likelihood of failure will therefore have higher discount rates and lower present values.
Another view of survival is that discounted cash flow valuations tend to have an optimistic bias and that the likelihood that the firm will not survive is not considered adequately in the value. With this view, the discounted cash flow value that emerges from the analysis in the prior section overstates the value of operating assets and has to be adjusted to reflect the likelihood that the firm will not survive to deliver its terminal value or even the positive cash flows that you have forecast in future years.
Should you or should you not discount value for survival?
For firms like Cisco and Motorola that have substantial assets in place and relatively small probabilities of distress, the first view is the more appropriate one. Attaching an extra discount for non-survival is double counting risk.
For firms like Ariba and Rediff.com, it is a tougher call and depends upon whether expected cash flows consider the probability that these firms may not make it past the first few years. If they do, the valuation already reflects the likelihood that the firms will not survive past the first few years. If they do not, you do have to discount the value for the likelihood that the firm will not survive the near future. One way to estimate this discount is to use the cash burn ratio, described earlier, to estimate a probability of failure, and adjust the operating asset value for this probability:
Adjusted Value = DCF Value of Operating Assets (1 – Probability of distress)
+ Distressed Sale Value (Probability of distress)
For a firm with a discounted cash flow value of $ 1 billion on its assets, a distress sale value of $ 500 million and a 20% probability of default, the adjusted value would be $ 900 million:
Adjusted Value = $ 1,000 (.8) + $500 (.2) = $ 900 million
There are two points worth noting here. It is not the failure to survive per se that causes the loss of value but the fact that the distressed sale value is at a discount on the true value. The second is that this approach revolves around estimating the probability of failure. This probability is difficult to estimate because it will depend upon both the magnitude of the cash reserves of the firm (relative to its cash needs) and the state of the market. In buoyant equity markets, even firms with little or no cash can survive because they can access markets for more funds. Under more negative market conditions, even firms with significant cash balances may find themselves under threat.
There will be no discount for failure for any of the firms being valued for two reasons. One is that you are using expected cash flows that adequately reflect the likelihood of failure. The other is that each of these firms has a valuable enough niche in the market, that even in the event of failure, there will be other firms interested in buying their assets at a fair value.
Cash and Non-operating Assets
The operating income is the income from operating assets, and the cost of capital measures the cost of financing these assets. When the operating cash flows are discounted to the present, you have valued the operating assets of the firm. Firms, however, often have significant amounts of cash and marketable securities on their books, as well as holdings in other firms and non-operating assets. The value of these assets should be added to the value of the operating assets to arrive at firm value. Some analysts prefer to consider the income from cash and marketable securities in their cash flows and adjust the discount rate to reflect the safety of these assets. When done right, this approach should yield the same firm value.
Cash and Marketable Securities
Firms often hold substantial amounts in cash and other marketable securities. When valuing firms, you should add the value of these holdings to the value of the other operating assets to arrive at the firm value. In this section, you first consider how to deal with cash and near cash investments (such as government securities) and then consider holdings of more risky marketable securities.
Cash and Near-cash Investments
Investments in short-term government securities or commercial paper, which can be converted into cash quickly and with very low cost, are considered near-cash investments. When valuing a firm, you add the value of cash balances and near-cash investments to the value of operating assets.
There is, however, one consideration that may affect how cash is treated. If a firm needs cash for its operations – an operating cash balance – you should consider such cash part of working capital requirements rather than as a source of additional value. Any cash and near-cash investments that exceed the operating cash requirements can be then added on to the value of operating assets. How much cash does a firm need for its operations? The answer depends upon both the firm, and the economy in which the firm operates. A small retail firm in an emerging market, where cash transactions are more common than credit card transactions, may require an operating cash balance that is substantial. In contrast, a manufacturing firm in a developed market may not need any operating cash. In fact, if the cash held by a firm is interest-bearing, and the interest earned on the cash reflects a fair rate of return, you would not consider that cash to be part of working capital. Instead, you would add it to the value of operating assets to value the firm.
Other Marketable Securities
Marketable securities can include corporate bonds, with default risk embedded in them, and traded equities, which have even more risk associated with them. As the marketable securities held by a firm become more risky, the choices on how to deal with them become more complex. You have three ways of accounting for marketable securities:
The simplest and most direct approach is to estimate the current market value of these marketable securities and add the value on to the value of operating assets. For firms valued on a going-concern basis, with a large number of holdings of marketable securities, this may be the only practical option.
The second approach is to estimate the current market value of the marketable securities and net out the effect of capital gains taxes that may be due if those securities were sold today. This capital gains tax bite depends upon how much was paid for these assets at the time of the purchase and the value today. This is the best way of estimating value when valuing a firm on a liquidation basis.
The third and most difficult way of incorporating the value of marketable securities into firm value is to value the firms that issued these securities and estimate the value of these securities. This approach tends to work best for firms that have relatively few, but large, holdings in other publicly traded firms.
Illustration 6.9: Cash and Marketable Securities
Each of the five firms that you are valuing holds cash and near-cash investments. In addition, Cisco, Motorola and Amazon own stock in other publicly traded firms. Table 6.14 summarizes these holdings at each of the five firms:
Table 6.14: Cash, Near-cash investments and Marketable Securities

Amazon
Ariba
Cisco
Motorola
Rediff
Cash & Near-cash Investments
$ 117
$ 50
$ 827
$ 3,345
$ 12
Other Marketable Securities
$ 589
$ 48
$ 1,189
$ 699
$ -
Total
$ 706
$ 98
$ 2,016
$ 4,044
$ 12
Note that the current market value of the securities owned by the firms is used and t the capital gains taxes have not been netted out in these holdings, since these firms are being valued on a going concern basis.
Holdings in Other Firms
In this category, you consider a broader category of non-operating assets, where you look at holdings in other companies, public as well as private. You begin by looking at the differences in accounting treatment of different holdings, and how this treatment can affect the way they are reported in financial statements.
Accounting Treatment
The way in which these assets are valued depends upon the way the investment is categorized and the motive behind the investment. In general, an investment in the securities of another firm can be categorized as a minority, passive investment; a minority, active investment; or a majority, active investment, and the accounting rules vary depending upon the categorization.
Minority, Passive Investments
If the securities or assets owned in another firm represent less than 20% of the overall ownership of that firm, an investment is treated as a minority, passive investment. These investments have an acquisition value, which represents what the firm originally paid for the securities, and often a market value. Accounting principles require that these assets be sub-categorized into one of three groups - investments that will be held to maturity, investments that are available for sale and trading investments. The valuation principles vary for each.
For investments that will be held to maturity, the valuation is at historical cost or book value, and interest or dividends from this investment are shown in the income statement.
For investments that are available for sale, the valuation is at market value, but the unrealized gains or losses are shown as part of the equity in the balance sheet and not in the income statement. Thus, unrealized losses reduce the book value of the equity in the firm, and unrealized gains increase the book value of equity.
For trading investments, the valuation is at market value and the unrealized gains and losses are shown in the income statement.
Firms are allowed an element of discretion in the way they classify investments and through this choice, in the way they value these assets. This classification ensures that firms such as investment banks, whose assets are primarily securities held in other firms for purposes of trading, revalue the bulk of these assets at market levels each period. This is called marking-to-market, and provides one of the few instances in which market value trumps book value in accounting statements.
Minority, Active Investments
If the securities or assets owned in another firm represent between 20% and 50% of the overall ownership of that firm, an investment is treated as a minority, active investment. While these investments have an initial acquisition value, a proportional share (based upon ownership proportion) of the net income and losses made by the firm in which the investment was made, is used to adjust the acquisition cost. In addition, the dividends received from the investment reduce the acquisition cost. This approach to valuing investments is called the equity approach.
The market value of these investments is not considered until the investment is liquidated, at which point the gain or loss from the sale, relative to the adjusted acquisition cost is shown as part of the earnings in that period.
Majority, Active Investments
If the securities or assets owned in another firm represent more than 50% of the overall ownership of that firm, an investment is treated as a majority active investment. In this case, the investment is no longer shown as a financial investment but is instead replaced by the assets and liabilities of the firm in which the investment was made. This approach leads to a consolidation of the balance sheets of the two firms, where the assets and liabilities of the two firms are merged and presented as one balance sheet. The share of the firm that is owned by other investors is shown as a minority interest on the liability side of the balance sheet. A similar consolidation occurs in the other financial statements of the firm as well, with the statement of cash flows reflecting the cumulated cash inflows and outflows of the combined firm. This is in contrast to the equity approach, used for minority active investments, in which only the dividends received on the investment are shown as a cash inflow in the cash flow statement.
Here again, the market value of this investment is not considered until the ownership stake is liquidated. At that point, the difference between the market price and the net value of the equity stake in the firm is treated as a gain or loss for the period.
Valuing Cross Holdings in other Firms
Given that the holdings in other firms can accounted for in three different ways, how do you deal with each in valuation?
If the holdings are treated as minority, passive investments, and the investments are reported in the balance sheet at the original cost or book value, you would value the firm in which these holdings are, and consider the proportion of the value that comes from the holding. For instance, assume that a firm owns 20% of another firm that has an estimated value of $ 500 million. The estimated value of this holding is $ 100 million.
If the holdings are minority, passive investments and the investments are recorded at market value, you have one of two choices. You can assume that the market is correct and use the assessed market value of these cross-held assets to value the firm. Alternatively, you can value the companies in which the investments have been made and add the estimated value of the holdings to the value of operating assets.
If the holdings are minority active interests, you need to value the firms in which these holdings are, and add the proportion of that value to the value of the operating assets of the firm.
If the holdings are majority, active interests, the income statements are consolidated. Consequently, the operating income of the firm includes the total operating income from the subsidiary, rather than the firm’s share of the subsidiary. You estimate the value of the subsidiary and add on the portion of the value that accrues to the parent company. Where, you might ask, is the minority interest that you see on the parent company’s balance sheet? You do not use it directly, since it reflects the book value of the holdings of others in the subsidiaries rather than market value.
Other Non-Operating Assets
Firms can have other non-operating assets, but they are likely to be of less importance than those listed above. In particular, firms can have unutilized assets that do not generate cash flows and have book values that bear little resemblance to market values. An example would be prime real estate holdings that have appreciated significantly in value since the firm acquired them, but produce little if any cash flows. An open question also remains about overfunded pension plans. Do the excess funds belong to stockholders and, if so, how do you incorporate the effect into value?
Unutilized Assets
The strength of discounted cash flow models is that they estimate the value of assets based upon expected cash flows that these assets generate. In some cases, however, this can lead to assets of substantial value being ignored in the final valuation. For instance, assume that a firm owns a plot of land that has not been developed, and that the book value of the land reflects its original acquisition price. The land obviously has significant market value but does not generate any cash flow for the firm yet. If a conscious effort is not made to bring the expected cash flows from developing the land into the valuation, the value of the land will be left out of the final estimate.
How do you reflect the value of such assets in firm value? An inventory of all such assets (or at least the most valuable ones) is a first step, followed up by estimates of market value for each of the assets. These estimates can be obtained by looking at what the assets would fetch in the market today or by projecting the cash flows that could be generated if the assets were developed and discounting the cash flows at the appropriate discount rate.
The problem with incorporating unutilized assets into firm value is an informational one. Firms do not reveal their unutilized assets as part of their financial statements. While it may sometimes be possible to find out about such assets as investors or analysts, it is far more likely that they will be uncovered only when you have access to information about what the firm owns and uses.
Pension Fund Assets
Firms with defined pension liabilities sometimes accumulate pension fund assets in excess of these liabilities. While the excess does belong to stockholders, they usually face a tax liability if they claim it. The conservative rule in dealing with overfunded pension plans would be to assume that the social and tax costs of reclaiming the excess funds are so large that few firms would ever even attempt to do it. The more realistic approach would be to add the after-tax portion of the excess funds into the valuation.
Illustration 6.10: Value of Other Non-Operating Assets
Amazon has holdings in several firms with whom it has strategic partnerships and they are reported below:
Company % Ownership
Della.com 21.9%
drugstore.com 26.7%
Gear.com 49.0%
HomeGrocer.com 28.0%
Kozmo.com 21.7%
Naxon Corporation 61.0%
Pets.com 48.4%
Amazon uses the equity-method to record its ownership in these firms and they are shown as investments in equity method investees on the balance sheet, with a value of $226.73 million. This estimate, however, reflects the book values of Amazon’s investments in these firms, not its market value. Since three of these firms are publicly traded, Amazon’s share of the market value of these firms is used for these firms, and book value is used for the non-traded firms.
The value of other non-operating assets at the five firms that you are valuing are reported in table 6.15:
Table 6.15: Cash and Non-operating Assets

Amazon
Ariba
Cisco
Motorola
Rediff.com
Majority Active Interests
$ -
$ -
$ -
$ -
$ -
Minority Active Interests
$ -
$ -
$ -
$ -
$ -
Minority Passive Interests
$ 371
$ 54
$ 7,032
$ 5,200b
$ -
Unutilized Assets
$ -
$ -
$ -
$ -
$ -
Pension Fund Overfunding
$ -
$ -
$ -
$ -
$ -
Total
$ 371
$ 54
$ 7,032
$ -
$ -
bMotorola’s holdings represent 16% of Nextel.
You should note that while there is no mention of unutilized assets in the financial statements, there well might well be such assets at each of these firms.
cash.xls: There is a dataset on the web that summarizes the value of cash and marketable securities by industry group in the United States for the most recent quarter.
Firm Value and Equity Value
Once you have estimates of the values of the operating assets, cash and marketable securities and the other non-operating assets owned by a firm, you can estimate the value of the firm as the sum of the three components.
To get to the value of the equity from the firm value, you subtract out the non-equity claims on the firm. Non-equity claims would include debt and preferred stock, though the latter are often treated as equity in financial statements. What debt should you subtract out? The debt that you considered in computing the cost of capital will be the debt that you should be netting out from firm value to get to the value of equity. To be consistent, therefore, you should consider both interest bearing liabilities and leases (in present value terms) to be debt, and use the estimated market value for both.
If the firm you are valuing has preferred stock, you would use the market value of the stock (if it is traded) or estimate a market value (if it is not) and deduct it from firm value to get to the value of common equity.
Illustration 6.11: Firm Value and Equity Value
The values of the five firms and the estimated values of equity in these firms are summarized in table 6.16:
Table 6.16: Firm and Equity Values

Amazon
Ariba
Cisco
Motorola
Rediff.com
Value of Operating Assets
$13,971
$17,816
$310,115
$66,139
$463
+ Cash, Near Cash & Marketable Securities
$706
$98
$2,016
$4,044
$12
+ Value of Operating Assets
$371
$54
$7,032
$5,200
$0
Firm Value
$15,048
$17,968
$319,163
$74,253
$474
- Debt
$1,459
$28
$827
$5,426
$0
- Preferred Stock
$0
$0
$0
$0
$0
Value of Equity
$13,589
$17,941
$318,336
$69,957
$474
The firm value incorporates both the operating and non-operating assets owned by these firms.
Summary
The value of a firm is the present value of its expected cash flows over its life. Since firms have infinite lives, you apply closure to a valuation by estimating cash flows for a period and then estimating a value for the firm at the end of the period – a terminal value. Many analysts estimate the terminal value using a multiple of earnings or revenues in the final estimation year. If you assume that firms have infinite lives, an approach which is more consistent with discounted cashflow valuation is to assume that the cash flows of the firm will grow at a constant rate forever beyond a point in time. When the firm that you are valuing will approach this growth rate, which you label a stable growth rate, is a key part of any discounted cash flow valuation. Small firms that are growing fast and have significant competitive advantages should be able to grow at high rates for much longer periods than larger and more mature firms, without these competitive advantages. If you do not want to assume an infinite life for a firm, you can estimate a liquidation value, based upon what others will pay for the assets that the firm has accumulated during the high growth phase.
Once the terminal values and operating cash flows have been estimated, they are discounted back to the present to yield the value of the operating assets of the firm. To this value, you add the value of cash, near-cash investments and marketable securities as well as the value of holdings in other firm to arrive at the value of the firm. Subtracting out the value of non-equity claims yields the value of equity in the firm.

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