BFF5520 Chap.11 Valuation
Valuation
Valuation aligns expected cash flow with the claim, horizon and discount rate being valued. Project or firm cash flow belongs with a required return on operating assets; equity cash flow belongs with an equity required return. Nominal cash flow requires a nominal rate and real cash flow a real rate.
Terminal value represents cash beyond the explicit forecast horizon and is measured at the horizon before being discounted to today. Enterprise value becomes equity value only after non-operating assets and senior claims are bridged once, without counting financing twice.
What this chapter covers
- 01
Claim identification
- 02
Cash-flow timing
- 03
Risk-matched discount rate
- 04
Nominal and real consistency
- 05
Constant-growth value
- 06
Terminal value
- 07
Enterprise value
- 08
Equity-value bridge
Worked example · free
Value a constant-growth dividend stream
- +1Next dividend is D1 = $1.60(1.04) = $1.664.
- +1At 10%, the capitalization spread is 0.10 - 0.04 = 0.06.
- +1Value is $1.664/0.06 = $27.73.
- +1At 11%, the spread is 0.11 - 0.04 = 0.07.
- +1Revised value is $1.664/0.07 = $23.77.
- +1Interpret the fall as the present-value effect of a higher required return on the same forecast cash flows.
Key terms
- Discount rate
- A discount rate is the required return that prices the timing and risk of a specified cash-flow claim.
- Constant-growth model
- The constant-growth model values a perpetually growing distribution as next cash flow divided by required return less growth.
- Terminal value
- Terminal value is the horizon-date value of cash flows occurring beyond the explicit forecast period.
- Enterprise value
- Enterprise value is the value of operating assets available to all capital providers before senior claims are deducted.
- Equity value
- Equity value is the residual value available to shareholders after debt and other senior claims.
- Excess cash
- Excess cash is cash not required for normal operations and may be added when bridging enterprise value to equity.
Valuation FAQ
Why must cash flow and discount rate match?
The rate prices a particular claim and convention. Firm cash flow with an equity rate, or real cash flow with a nominal rate, combines inconsistent objects and biases present value even when the arithmetic is executed correctly.
Why does the constant-growth model use next dividend?
The valuation date is immediately before the first forecast payment. If the latest dividend has already been paid, it is D0 and must be grown once to D1 before capitalization. Using D0 shifts timing by one period.
How should terminal value be used?
Estimate terminal value at the end of the explicit forecast using sustainable long-run assumptions, then discount it back. Report how much total value comes from the terminal component and test its sensitivity.
How does enterprise value become equity value?
Add excess cash and other non-operating assets to enterprise value, then subtract debt and other senior claims. Use values from the same date and avoid subtracting financing already included in the cash-flow definition.
What makes a terminal growth rate defensible?
It should be sustainable relative to the economy, competition, reinvestment and returns on new investment, and it must remain below the required return in a constant-growth formula. Near-equality makes value extremely unstable.
Exam move
Begin every valuation with a one-line claim definition: who receives the cash, when it arrives and whether financing is included. Match project, enterprise, debt or equity cash flow to the corresponding rate. Recompute a constant-growth example by changing growth and required return separately and explain the direction. Build terminal value at the horizon, then discount it rather than treating it as a present amount.
Keep an enterprise-to-equity bridge visible and ensure debt is removed only once. Finish with a sensitivity check that preserves required return above perpetual growth and states the implied long-run operating economics. Create a consistency checklist with claim, currency, inflation convention, tax treatment, risk and timing. Apply it before entering a discount factor.
Draw the explicit forecast period and place terminal value at the end of that horizon; discount both forecast cash flows and terminal value back to the same valuation date. For constant growth, label the amount just paid as period zero and calculate next period cash flow before dividing by the spread between required return and growth.
Reconcile enterprise value to equity value using debt and any other non-equity claims only after checking what the cash-flow definition already excluded. Build a two-way sensitivity table for required return and perpetual growth, but reject combinations that violate economic plausibility instead of treating every cell as equally credible.
Translate the terminal assumptions into reinvestment and return on new capital where possible. Finally, compare the implied value with observable operating scale or multiples as a diagnostic, not as a substitute for the model. Large disagreement should trigger an assumption audit before a narrative justification.
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