FIN.7:5 - Archetypal Grounding

Suppose two years of FCFF are 10 each, the matching WACC is 10%, and continuing year-3 FCFF is sustainably 10 with zero growth. Terminal value at year 2 is 100. Operating enterprise value is 10/1.1 + (10+100)/1.1² = 100. If debt with a market value of 30 remains outstanding in the acquired company and the company includes excess cash of 10 that is freely transferable after closing, with no other claim adjustment, standalone equity value is 80. FIN.9 compares that interest’s value with the price. A price of 100 for the equity is not made reasonable by calling the operating business worth 100.

Now suppose a separately supported continuing forecast reaches year-3 after-tax operating profit 12. With a qualified supplied new-capital return of 15%, growth of 3% and stable existing productivity, reinvestment is 3%/15% = 20% of profit, or 2.4 in year 3; FCFF is 9.6. At terminal WACC 10%, year-2 continuing value is 9.6/(0.10−0.03) = 137.14. Retaining explicit-year FCFF of 10 and 10 and the 10% intervening return gives enterprise value 130.70 and equity value 110.70 with the same claims.

Suppose instead that 15% describes old assets and the new-capital return must be constructed. The operating plan adds equipment 3.2 and operating working capital 0.8 at a year end, before a full year of production. Added annual revenue 2.4 less cash operating cost 1.6 and depreciation 0.4 gives operating profit 0.4. With matching tax depreciation and a same-year usable operating tax of 25%, incremental after-tax profit is 0.4 × 0.75 = 0.3. The return on the preceding 4 of new operating capital is therefore 0.3/4 = 7.5%. In this constructed case, ongoing maintenance expenditure offsets depreciation, preserves that capacity and profit, and leaves working capital stable. The plan supports repeating the addition and scaling it proportionally over the relevant range; existing-asset productivity stays constant.

At that 7.5% return, growing year-3 profit 12 by 3% requires 0.36 extra profit in year 4, hence 0.36/0.075 = 4.8 net investment in year 3. Reinvestment absorbs 40%; year-3 FCFF is 7.2, year-2 continuing value 102.86, enterprise value 102.36 and equity value 82.36. If the new capacity’s annual cash cost rises from 1.6 to 1.8, its after-tax profit becomes 0.15 and return 3.75%; holding the other conditions, reinvestment for the same growth absorbs 80%, leaving FCFF 2.4. Rebuild the existing-profit forecast too if the cost change affects old capacity. Neither the old 15% average nor the required 10% return can replace this operating calculation. Each continuing premise requires the explicit forecast to support the transition; growth alone does not select the more favorable value.

A separate market comparison uses two economically comparable businesses on matched dates and definitions. One has equity value 180, debt 40 and excess cash 20: operating enterprise value 200 divided by EBITDA 20 gives 10 times. The other has equity 148, debt 70 and excess cash 20: enterprise value 198 divided by EBITDA 22 gives 9 times. Suppose the target’s reported EBITDA 13 includes a demonstrated one-time gain of 1 and the comparable figures exclude such gains. Its matching measure is 12. If the evidence supports using 9–10 times without further adjustment, operating value is 108–120 and equity value 88–100 after debt 30 and excess cash 10. Merely sharing an industry would not establish this comparability. Compare the implied growth, investment and risk with the income valuation before preferring an estimate; do not average the ranges to hide disagreement.

Under a different, liquidation premise, suppose present values of realizable equipment, receivables and cash are 70, 25 and 10. Prior-claim settlements are 30 and additional tax and closure costs 5, all on the same date basis. The residual is 70. That calculation supplies a liquidation equity estimate, not an extra asset to add to the going-concern equity value.