Running head: METHODS OF VALUATION 1

Methods of Valuation
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METHODS OF VALUATION 2

Uses of WACC and APV

A set of capitals are needed to run any company/firm which are often in form of common
shares (equity), preferred stock and debt. WACC stands for weighted average cost of capital
which means the calculation of costs of capital of a company in which each asset is
proportionately weighted (Martins & Martins, 2015). It is a capital ratio structure which can be
used by the investors to evaluate projects with risks i.e. whether a company should invest in
buying new assets from debt or buy it from equity. It takes average future fund costs into
consideration by weighing cost of each capital by its part in financial model of the company.
WACC is used when the leverage is minimum between the equity-debt ratios of both project and
the company which means it only works under the condition of unchanged capital which makes
it a constant yet inflexible method (Martins & Martins, 2015). That means a company should
only invest when its return is greater than WACC.
WACC basically gives an insight on the finance, which the company has to pay their
assets. It is used when a company wants to make an ideal capital structure. It is also used as a
hurdle rate which provides profit opportunity analysis when investments are made (Martins &
Martins, 2015). WACC is also used as a measure of value creating in calculating Economic
Value Added. To calculate the NPV, it is used as a discount rate in business.
On the other hand, APV stands for Adjusted Present Value and is used when there is an
expected fluctuation in financial model of the company because it covers all the impacts of debt
financing. It is an alternative to WACC and is used to calculate the profit opportunity when a
company invests in a project on the basis of equity cash flow only, without any debt which helps
in tax deductions (Martins & Martins, 2015). These debt financings help in boosting the final
profits of a project with connected high debt value by repaying from stockholder’s equity cash
flow. It is a similar measure technique as NPV but it uses cost of equity only instead of all other
ratios of capitals i.e. WACC which makes APV a flexible method of evaluation. It is the sum of
base – case value (which is managing the project finances on equity capital only) and the effect
of debt on company’s value such as tax shields, hedges, subsidies etc (Martins & Martins, 2015).
unlike WACC which somehow fails to take into account the side effects of financial values.
Effect of Personal Tax on both Methods
Tax effect both methods on the basis of interest tax shield. Suppose you borrow 1000$ on
the interest rate of 9%, you will have to pay 90$ as interest and tax on remaining 910$ which will
be 309$ at the tax rate of 34%. Now If the interest rate is 12% you will give off 120$ as interest
and 299$ as tax on the remaining amount of 880$ with 34% tax rate (Stanton & Seasholes,
2005). The more interest you pay, the less you pay for tax. This is called interest tax shield. The
after-tax debt capital is essential part of WACC as it is the average of all the capital costs. So this
means low value of WACC leads to higher value of interest which in turn makes the tax shield
high. Similarly, as APV also considers effects of interest tax shield as discussed earlier, so it
means high value of the APV means more tax rate and more interest rate shield.
The overall relationship between tax and WACC is not that simple to understand.
Multinational companies trigger a heavy load of taxes within their finance activities and treasury.
These can include income tax, sales tax, corporate tax, with-holding tax, capital gain tax, stamp
duties, and value added tax(Stanton & Seasholes, 2005). However, it is not necessary that a
particular company need to give all of these taxes. This measure will be determined by the tax
regulation policies of the government within the country.
For example, the tax regulation policies in China would differ from those of the United States.
That is why business in both these countries have to adhere to different tax regulation rules. In
METHODS OF VALUATION 3

addition to this, the tax treatment for different capital components will vary as well. This will
largely depend on the corporate tax system related to WACC within a country and for a
particular business (Stanton & Seasholes, 2005).. It is important to keep in mind that the cost of
debt in most cases is tax deductible. On the other hand, the cost of equity is not so.
Before talking about the impact of tax regulation on WACC or APV, it is important to
understand the formulas behind each of them. In terms of WACC, the calculation formula is as
follow:
WACC= V/E ∗Re+ V/D ∗Rd∗(1−Tc)
In this equation, E stands for Market Value of the company’s equity. D stands for market value
of the company’s firm. While V is E+D, which basically stands for total market value for the
company’s financing. Here, Re is the cost of equity and Rd is the cost of debt. On the other hand,
E/V is the percentage of financing that is equity, while V/D is the percentage of financing that is
debt. Lastly, Tc is the calculated corporate tax rate (Stanton & Seasholes, 2005). In this equation,
the corporate tax rate on the debt financing is adjusted by multiplying it by the factor (1-tc).
Multiplying the cost of debt with the factor (1-tc) helps to derive the after-tax cost of debt of the
company.
The company’s corporate income tax is inversely proportional to the calculated WACC.
This is because the higher rate of income tax produces a larger tax shield. In some cases, the
companies are not organized as proper organizations. In this case, they usually think they will be
able to escape the crunches of the tax-shield effect (Stanton & Seasholes, 2005). However, that is
not the case. When a loan is made of a business, the interest on that loan is tax deductible, which,
in turn, reduces the overall profit of the company. Note that the loan is made to the business itself
and not the business owner. In businesses that are not organized as proper organizations, the
profit flows directly to the business owner (Stanton & Seasholes, 2005). Due to this, the business
owner pays the income tax on it and thus limits the overall profitability of the business. As a
result, the owner needs to give low tax returns.
METHODS OF VALUATION 4

Uses of IRR as Alternative Valuation Metrics

IRR stands for Internal Rate of Return and runs on the concept of 0 Net Present Value. It
basically measures the performance of a project, financial expenditures and investment over a
period of time (Valach, 2013). Mathematically, instead of deciding discount rates and applying
certain factors for projects cash flow to produce NPV it assumes the 0 NPV for the project to
determine the discount rate. It is used when you need to judge the profit practicality of multiple
projects in comparison (Vance, 2018). Higher IRR value than the cost of capital means the
company should invest in the project and lower IRR value means it shouldn’t. As it is a quantity
of rate, it demonstrates, compares and asses the investment made in a project considering how
effective and systematic it is. Investors mostly use this method of valuation when the concept of
“time value of money is involved” (Valach, 2013). It is also used as an effective interest rate
when loans are involved. It is used when u need a benchmark amount for a project which can be
assessed according to company’s financial model (Vance, 2018). Being a rate quantity, it is also
used to check the yield performance on the basis of profitability which tells the viability of a
project.
Drawbacks of IRR
Although it is a time projected method but it doesn’t define the overall issuing of cash flow in the
entire project. It is not flexible enough for negative and positive cash flows (Osborne, 2010). The
magnitude and length of a project is also not defined in this valuation method. Future market
conditions and interest rates are also overlooked.
This method cannot be used with multiple projects as IRRs cannot be added. It will take addition
of cash flow individually and then calculating the IRR out of the sum of all cash flows which
makes it a lengthy method (Osborne, 2010). Thus comparing different projects is restricted in
this method.
Uses of Cash Multiple as Alternative Valuation Metrics
Cash multiples evaluates future profit returns which are more than the starting investments. It
involves the basic insight into how much money the investor will make by financing a certain
project. For example, a project started with 1-dollar investment can either give the original
investment back or gives a profit of extra 1 dollar with a two x multiple (Arjunan, 2017). Cash
multiple determines the number of x multiple of a future investment. It gives insight into the total
cash flows of an investment with continuous flows and total returns which is then compared by
total equity.
Drawbacks of Cash Multiple
The cash multiple method comes with its due share of advantages and disadvantages. One
of the major disadvantage of this method is that it takes a highly complex information and
presents in into a single value or a series of values (Arjunan, 2017). This disregards the other
external factors that impact the intrinsic values of the company, such as its growth or decline.
In addition to this, using cash multiple method can also place difficulty in executing a
comparative study between companies or their assets. This can happen because different
companies may have similar business operation, however, each is unique in terms of their
accounting policies (Arjunan, 2017). This can cause the multiples to be easily misinterpreted
and, thus, comparisons are not that conclusive. Consequently, the companies need to adjust them
for different accounting policies for a comparative study.
Lastly, cash multiples analysis completely disregards the future of the company. This
means it is entirely static (Arjunan, 2017). It only takes a certain time period of the company into
consideration and calculates the company’s growth and business operations in that time frame.
METHODS OF VALUATION 5

Sensitivity Analysis and Impact on Evaluation

Sensitivity analysis is used to determine the sensitivity of the output variable to change
the other variables provided that the input variable remains the same. This analysis is primarily
used in capital budgeting decisions to determine how the impact of change in the input variable
effects the output variable (Tsanakas & Millossovich, 2015). In this respect, the input variable
includes marginal tax rates, sales, fixed costs, variable costs, cost of capital, etc. On the other
hand, the output variable includes the net present value of the project (NPV), discounted payback
period, and the internal rate of return (IRR) (Tsanakas & Millossovich, 2015). The sensitivity
analysis is able to provide a better understanding of the risks involved in any project.
There are several steps that are involved in conducting the sensitivity analysis for any
project. These include:
1. Determining the input and output variables
2. Calculating the baseline values of the outputs through the baseline values of the input
variables.
3. Now, change the value of one of the input variables and keep the other variables constant.
After that, calculate the new output variables and analyze this change in value.
4. You can analyze this by calculating the percentage change of the input and output
variables as compared to the baseline values (Tsanakas & Millossovich, 2015).
5. Now, simple calculate the sensitivity by dividing the percentage change in output
variable by the percentage change in input variable.
METHODS OF VALUATION 6

References
Arjunan, K. (2017). A Resolution to the Problem of Multiple IRR: A Modified Capital
Amortization Schedule (MCAS) Method for Non-Normal Cash Flows (NNCF) to Obtain a
Unique IRR. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.3000729
Martins, E., & Martins, V. (2015). ACCOUNTING AND FINANCE: THE RECKLESS
USE OF WACC. Revista Universo Contábil, 25-46. https://doi.org/10.4270/ruc.2015102
Osborne, M. (2010). On the Meaning of Internal Rates of Return and Why an Internal Rate
of Return is Not an Investment Criterion. SSRN Electronic Journal.
https://doi.org/10.2139/ssrn.1634819
Stanton, R., & Seasholes, M. (2005). The Assumptions and Math Behind Wacc and Apv
Calculations. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.837384
Tsanakas, A., & Millossovich, P. (2015). Sensitivity Analysis Using Risk Measures. Risk
Analysis, 36(1), 30-48. https://doi.org/10.1111/risa.12434
Vance, D. (2018). A New Algorithm for Internal Rate of Return. Journal Of Economics,
Management And Trade, 21(8), 1-9. https://doi.org/10.9734/jemt/2018/43914
Valach, J. (2013). Internal Rate of Return or Modified Internal Rate of Return. Český
Finanční A Účetní Časopis, 2013(3), 114-121. https://doi.org/10.18267/j.cfuc.375