Variations on DCF Models

The model that we have presented in this section, where expected cash flows are discounted back at a risk-adjusted discount rate, is the most commonly used discounted cash flow approach but there are two widely used variants. In the first, we separate the cash flows into excess return cash flows and normal return cash flows. Earning the risk adjusted required return (cost of capital or equity)is considered a normal return cash flow but any cash flows above or below this number are categorized as excess returns; excess returns can therefore be either positive or negative. With the excess return valuation framework, the value of a business can be written as the sum of two components:
Value of business = Capital Invested in firm today + Present value of excess return cash flows from both existing and future projects

If we make the assumption that the accounting measure of capital invested (book value of capital) is a good measure of capital invested in assets today, this approach implies that firms that earn positive excess return cash flows will trade at market values higher than their book values and that the reverse will be true for firms that earn negative excess return cash flows.

In the second variation, called the adjusted present value (APV) approach, we separate the effects on value of debt financing from the value of the assets of a business. In general, using debt to fund a firm’s operations creates tax benefits (because interest expenses are tax deductible) on the plus side and increases bankruptcy risk (and expected  bankruptcy costs) on the minus side. In the APV approach, the value of a firm can be
written as follows:
Value of business = Value of business with 100% equity financing + Present value of Expected Tax Benefits of Debt – Expected Bankruptcy Costs

In contrast to the conventional approach, where the effects of debt financing are captured in the discount rate, the APV approach attempts to estimate the expected dollar value of debt benefits and costs separately from the value of the operating assets.While proponents of each approach like to claim that their approach is the best and most precise, P.S that the three approaches yield the same estimates of value, if we make consistent assumptions.