Valutico brings consistency to three of the primary valuation methods on the Valutico platform—DCF (Dynamic WACC), Adjusted Present Value (APV), and Flow-to-Equity (FTE)—by standardizing the periodic cost of capital used across these methods.
This enhancement ensures they now align to produce the same valuation results, providing a unified and standardized approach that meets the rigorous expectations of our users and enhances the reliability of valuations.
Understanding the Periodic Cost of Capital
The periodic cost of capital calculation is essential to achieving consistency across the DCF, APV, and FTE valuation methods. Here’s how we approach this in two main steps:
Perpetual Discounting of Free Cash Flow to the Firm (FCFF) and Tax Shield on Interest:
We start with the Terminal Year (TY), where we discount the free cash flow (FCF) in perpetuity using the unlevered cost of equity and a perpetual growth rate. This calculation provides the unlevered enterprise value at the last year before TY. Similarly, for the tax shield, we discount the TY tax shield in perpetuity using the unlevered cost of equity and perpetual growth rate to determine its value at the last year before TY.
Backward Calculation for Each Year’s Unlevered Enterprise Value and Tax Shield:
Moving backward from the Terminal Year, we calculate each year’s unlevered enterprise value by discounting the sum of the next year’s unlevered enterprise value and forecasted FCF using the unlevered cost of equity.
For the tax shield on interest, we apply a similar backward calculation. Each year’s tax shield value is determined by discounting the sum of the next year’s discounted tax shield and forecasted tax shield, again using the unlevered cost of equity.
By summing the unlevered enterprise value and the tax shield value at each period, we derive the firm’s Enterprise Value annually. Finally, incorporating Net Debt gives us the Equity Value, which is essential for determining the company’s capital structure (Debt-to-Equity and Debt-to-Capital ratios) at each period.
Now that we have determined the capital structure at each period, we use these ratios in our calculations of the cost of equity and the weighted average cost of capital (WACC) for each year.
Cost of Equity Calculation
The cost of equity is calculated using the Capital Asset Pricing Model (CAPM). In this updated approach, the equity beta (re-levered beta) calculation relies on the Modigliani-Miller (M-M) approach rather than the Harris-Pringle method.
The key difference between the M-M and Harris-Pringle approaches is the treatment of the tax shield. The M-M method excludes the tax shield effect in beta calculations as the tax shield has already been accounted for in the capital structure determination.
Cost of Debt Calculation
The cost of debt calculation remains consistent with prior methods, with one key update: the pre-tax cost of debt is now derived from the blended interest rate available in the valuation-relevant cash flows.