BBA SEM – V

Financial Modelling

Assignment – III

Session 2022 – 2025

Submitted To Submitted by
Pratyush Singh Negi
Ms. Shweta Aneja
BBA M-3
35913701722

Assignment Marks Date of Submission

05.11.2024
 Q1.). Explain the differences between Free Cash Flow to the Firm (FCFF) and Free
Cash Flow to Equity (FCFE) in the Discounted Cash Flow (DCF) method. Also discuss
how each is calculated, their specific uses, and how they impact a company's valuation.

Ans-1.

In the Discounted Cash Flow (DCF) method, Free Cash Flow to the Firm (FCFF) and Free Cash
Flow to Equity (FCFE) are two distinct measures used to value a company. Both metrics represent
the cash flows available for valuation, but they differ in terms of who receives the cash flows and
how they are calculated.

1. Differences Between FCFF and FCFE

 Free Cash Flow to the Firm (FCFF): This represents the cash flows available to all
providers of capital, including both debt and equity holders. It considers the company's
operations independently of its financing structure.
 Free Cash Flow to Equity (FCFE): This measures the cash flows available to equity
holders specifically, after accounting for debt obligations. It's essentially the portion of
FCFF left for shareholders once debt-related payments are made.

2. Calculation of FCFF and FCFE

 FCFF Calculation:
FCFF=EBIT×(1−Tax Rate)+Depreciation−CAPEX−Change in Working Capital\text{FCF
F} = \text{EBIT} \times (1 - \text{Tax Rate}) + \text{Depreciation} - \text{CAPEX} -
\text{Change in Working
Capital}FCFF=EBIT×(1−Tax Rate)+Depreciation−CAPEX−Change in Working Capital
where:
o EBIT = Earnings Before Interest and Taxes
o CAPEX = Capital Expenditures
o Change in Working Capital = Adjustments for current assets and liabilities
 FCFE Calculation:
FCFE=FCFF−Interest Expense×(1−Tax Rate)+Net Borrowing\text{FCFE} = \text{FCFF}
- \text{Interest Expense} \times (1 - \text{Tax Rate}) + \text{Net
Borrowing}FCFE=FCFF−Interest Expense×(1−Tax Rate)+Net Borrowing where:
o Interest Expense = Cost of debt payments
o Net Borrowing = New debt raised minus debt repayments

3. Specific Uses

 FCFF: Used for valuing the entire firm, regardless of its capital structure. This is
especially useful when the capital structure is expected to change or when comparing
companies with different debt levels. The calculated firm value (enterprise value) includes
both debt and equity; to find equity value, we subtract net debt.
 FCFE: Used to directly value equity, so it's often applied when looking at companies with
stable capital structures or low levels of debt. Since FCFE represents cash flows available
solely to equity holders, it’s appropriate for determining intrinsic value from an equity
perspective.
4. Impact on Valuation

 FCFF Valuation: When discounting FCFF, we use the Weighted Average Cost of Capital
(WACC), which incorporates both the cost of equity and cost of debt. The result is the
enterprise value, and subtracting net debt gives the equity value. This approach captures
the overall value of the business and considers the firm as a whole.
 FCFE Valuation: For FCFE, we discount cash flows using the Cost of Equity (not
WACC), reflecting the return required by equity holders. The result is the equity value
directly. This method can yield a higher valuation for firms with lower debt obligations or
when equity holders are prioritized in the cash flows.

Q2.) Compare and contrast the Dividend Discount Model (DDM) and Precedent
Transaction Analysis as valuation methods. Also discuss the underlying assumptions of
both methods. Explain in which situations each model is most appropriate.

Ans-2.
The Dividend Discount Model (DDM) and Precedent Transaction Analysis are two common
valuation methods used in finance, but they have different underlying principles, methodologies,
and applications. Here’s a detailed comparison of both methods.

1. Dividend Discount Model (DDM)

The Dividend Discount Model values a company based on the present value of its expected future
dividends. This model assumes that a stock's intrinsic value is the sum of all future dividends,
discounted back to their present value.

 Formula: The most common form is the Gordon Growth Model, which assumes dividends
grow at a constant rate:

 Underlying Assumptions:
o The company pays consistent and predictable dividends.
o Dividend growth rate is stable and predictable over time.
o Investors can estimate the required rate of return (cost of equity) accurately.
o Suitable mainly for mature, stable companies with a history of dividend payments.
 Best Suited For: The DDM is most appropriate for companies that have:
o A stable dividend policy (e.g., mature companies in utilities, consumer staples).
o Reliable and predictable earnings.
o Limited potential for high growth (since high-growth companies usually reinvest
earnings rather than paying dividends).
2. Precedent Transaction Analysis

The Precedent Transaction Analysis method, also known as Comparable Transactions Analysis,
involves valuing a company by analyzing recent transactions of similar companies in the industry.
This approach assumes that past acquisition prices represent an indicator of what the market is
willing to pay for a similar business today.

 Process:
1. Identify comparable transactions within the same industry, ideally with similar
size, geographic focus, and growth potential.
2. Analyze multiples paid in these transactions, such as Enterprise Value/EBITDA,
Price/Earnings, or Enterprise Value/Sales.
3. Apply the average or median multiple from these transactions to the target
company’s financials.
 Underlying Assumptions:
o Recent market transactions are indicative of current market valuation.
o Market conditions, industry trends, and the motivations behind past transactions
are relevant and comparable to the target.
o Valuation multiples from past deals are suitable benchmarks for the current
company.
 Best Suited For: Precedent Transaction Analysis is commonly used in situations where:
o There is a need to determine market value in an acquisition or merger context.
o The target company operates in an industry where acquisitions are frequent and
comparable data is available.
o The method is particularly valuable in M&A transactions as it provides insight into
what actual acquirers have recently paid in similar deals.

3. Situational Appropriateness

 Dividend Discount Model (DDM):

o Most appropriate for valuing well-established companies that pay regular dividends, such
as utilities or consumer staples.
o Unsuitable for high-growth companies, startups, or companies that do not pay dividends.
 Precedent Transaction Analysis:
o Ideal for M&A valuation and in industries where there are frequent, comparable
transactions.
o Less reliable if there are limited comparable transactions or if market conditions or
transaction motivations differ widely.
 Q3.) Evaluate the use of Market-Based Methods such as Earnings Per Share (EPS) and
valuation multiples (e.g., P/E ratio, EV/EBITDA) in company analysis. Explain the
benefits and limitations of using these market-based approaches.

Ans-3.

Market-based methods, including Earnings Per Share (EPS) and valuation multiples like the
Price-to-Earnings (P/E) ratio and Enterprise Value-to-EBITDA (EV/EBITDA), are widely used in
company analysis to estimate a company’s market value relative to its earnings or cash flows.
These methods offer a quick and comparative way to assess valuation based on market trends and
peer performance. Here’s an evaluation of these approaches, covering the benefits, limitations,
and situations in which they are most appropriate.

1. Earnings Per Share (EPS)

EPS is a measure of the portion of a company's profit allocated to each outstanding share of
common stock. It’s a key metric for understanding profitability from a shareholder’s perspective.

 Formula:

 Benefits:
o Simple and Intuitive: EPS provides a straightforward view of profitability per
share, making it easy for investors to assess earnings potential.
o Widely Used: EPS is a standardized metric, frequently used in financial analysis,
allowing easy comparison across companies.
o Foundation for Other Metrics: EPS is often used as a base for calculating valuation
multiples like the P/E ratio.
 Limitations:
o Ignores Capital Structure: EPS doesn’t account for the company’s debt or preferred
stock structure, which can affect risk and return.
o Subject to Accounting Adjustments: EPS can be influenced by non-operational
items, one-time gains or losses, and accounting choices, which may distort actual
performance.
o Vulnerable to Share Dilution: EPS can be diluted if the company issues additional
shares, potentially misleading investors if the diluted impact isn’t clear.

2. Price-to-Earnings (P/E) Ratio

The P/E ratio is a valuation multiple that compares a company’s current stock price to its per-
share earnings. It reflects how much investors are willing to pay for each dollar of earnings and is
often used to evaluate a company's relative value in the market.
  Formula:

 Benefits:
o Easy Comparability: P/E ratios allow for quick comparison across companies
within the same industry to determine relative valuation.
o Investor Sentiment: A high P/E often indicates positive market expectations, while
a low P/E may suggest undervaluation or low growth expectations.
o Versatility: The P/E ratio can be calculated using historical, current, or forward
EPS, offering flexibility based on the analysis objective.
 Limitations:
o Highly Sensitive to Earnings Volatility: Companies with volatile earnings or low
profitability can yield misleading P/E ratios.
o Ignores Debt and Cash: P/E does not account for leverage, so two companies with
similar P/E ratios could have very different risk profiles.
o Industry Limitations: P/E ratios are less useful for industries where earnings aren’t
the primary value driver, such as startups or asset-heavy businesses (e.g., real
estate).

3. Enterprise Value-to-EBITDA (EV/EBITDA)

The EV/EBITDA multiple is a valuation ratio that compares a company’s total enterprise value
(EV) to its EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). It’s often
preferred over the P/E ratio because it is less affected by capital structure and tax rates.

 Formula:

where:

o Enterprise Value (EV) = Market Capitalization + Total Debt - Cash

 Benefits:
o Accounts for Capital Structure: By focusing on EV, this multiple includes both
equity and debt holders, making it more suitable for comparing companies with
different levels of leverage.
o Minimizes Accounting Distortions: EBITDA is less subject to accounting
variations, such as depreciation policies, than net income, making EV/EBITDA
more reliable across companies.
o Useful for Non-Profitable Companies: EV/EBITDA can be used even when a
company has little or no net income, unlike P/E, which relies on positive earnings.
  Limitations:
o Ignores Capital Expenditures: EBITDA does not capture capital expenditures,
which are essential for asset-heavy industries, so EV/EBITDA may overvalue
capital-intensive businesses.
o Can Oversimplify Comparisons: Different companies may have varying levels of
depreciation or asset bases, making EV/EBITDA comparisons less meaningful in
some industries.
o Potential for Manipulation: EBITDA can be adjusted in ways that may not fully
reflect cash flows, potentially leading to overstated financial health.

4. Benefits of Market-Based Methods Overall

 Quick and Comparatively Simple: Market-based methods provide a quick snapshot of a

company’s valuation compared to peers, making them widely useful in screening and
preliminary analyses.
 Reflect Market Sentiment: These methods incorporate market perceptions and investor
expectations, which can provide insights into how the market values certain business
models or sectors.
 Broadly Applicable: Valuation multiples can be applied across a wide range of industries
and sectors, given the availability of comparable data.

5. Limitations of Market-Based Methods Overall

 Reliance on Market Conditions: Market-based valuations fluctuate with broader market

conditions and investor sentiment, which may lead to overvaluation or undervaluation
based on current trends rather than intrinsic value.
 Lack of Company-Specific Insight: These methods may not fully capture a company's
unique characteristics, competitive advantages, or risks, which are better addressed in
intrinsic valuation methods like DCF.
 Difficulty Finding True Comparables: In some industries, finding truly comparable
companies is challenging, which can make relative valuations less reliable.

6. Situations Where Market-Based Methods Are Most Appropriate

 Peer Comparisons: These methods are effective for quick peer comparisons within
industries where standardized metrics like P/E and EV/EBITDA are commonly used.
 Short-Term Investment Decisions: Market-based methods are suitable for short-term
investors who want to understand relative market positioning rather than intrinsic value.
 When Valuing Mature, Established Companies: Multiples like P/E and EV/EBITDA are
effective for companies with stable earnings and cash flows, making them useful for
established businesses with predictable financial performance.