Corporate Finance

Free Cash Flow Valuation 
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Step 2: Estimate a Suitable Discount Rate for the Project

A company can use its weighted average cost of capital based on its target capital structure only if the project

has the same (systematic) risk as the parent. If the company has a different capital structure in mind, suitable

adjustments for the discount rate should be made. The discount rate should reflect the capital structure of the

project. To calculate the discount rate:

• Estimate the asset beta for the project using the relationship.
  βA = βE (E/V) where E/V is the equity-to-value ratio and βE is the equity beta. The asset beta may also be
  obtained by taking the average asset betas of comparable firms in the industry.


• Re-lever the asset beta at various debt ratios (say, from 0 to 60 percent using the same relationship and
  find levered equity beta for the project.


• Estimate cost of equity at various debt ratios.


• Similarly, estimate cost of debt at various debt ratios.


• Calculate WACC as the weighted average of costs of debt and equity, the weights being target, market
  value debt-to-value and equity-to-value ratios respectively.

Step 3: Calculate the Present Value of Cash Flows

Since the project is usually a going concern,

Value of the project = PV of cash flows during the forecast period + Terminal value

We can set the forecast period in such a way that the project reaches a stable phase after that. In other

words, we are assuming that the project will grow at a constant rate after the forecast period. The period of

high growth can be anywhere from 3–20 years (may be even more for some computer software firms)

depending on the type of business, size of the market, entry barriers, availability of substitutes, number of

players in the market and so on.

Step 4: Estimate the Terminal Value

The terminal value is the present value of cash flows occurring after the forecast period. If we assume that

cash flows grow at a constant rate after the forecast period, the terminal value:

T.V = [CFt (1 + g)]/k – g

where

CFt= cash flow in the last year,

g= constant growth rate, and

k= discount rate.

Step 5

Add present value of terminal value.