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1.7 Valuation Frameworks

Chapter 6, “Putting It All Together: Valuation Frameworks,” pulls all the concepts presented in the previous chapters together and shows how to evaluate Equation 1 and determine a measure of value for a project. At the end of Chapter 5, we explain how the creation of costs and benefits due to capital structure decisions, such as tax shields, alters the value of the left-hand side of the balance sheet. This means that the cash flow effects of capital structure decisions need to be projected out so that the present value implications of these decisions can be measured. This leads to two different ways of computing the present value of a project using Equation 1, depending on how changes in the capital structure are likely to occur. We will first demonstrate the technique known as adjusted present value (APV). APV incorporates the effects of all time-varying capital structure decisions and is therefore a universal methodology for evaluating the present value of a project. However, in the special case where the debt-to-equity ratio of a project is kept constant through time, we will show that the APV approach can be simplified to another approach utilizing the weighted average cost of capital (WACC).8 The WACC-based approach allows for a much simpler and faster evaluation of Equation 1, but it can be used only under the restriction that the proportion of debt and equity on the right-hand side of the balance sheet remain the same through time (though the total amount of debt and equity may increase or decrease through time). Finally, we will introduce another special case of APV in Chapter 6 known as flow to equity (FTE). The FTE approach is widely used in the field of private equity, especially in buyout situations. We will show how to utilize FTE and how FTE evolves from APV, and we will also show FTE’s relationship to WACC.

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