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Subject: Finance

Topic: Accounting and Managerial Finance

This paper will discuss valuation of a company using the discounted cash flow method. It is worth noting at this stage that valuing a company is not a simple task but it is very crucial for effective management. The cash flow method considers all cash flows emanating from the investment made by the company. Therefore, non cash flows items such as depreciation charges and other accounting policy adjustments are not relevant to this kind of valuation. Valuation of Henkel using the enterprise discounted cash flows will seek to estimate the streams of cash flows arising from the company’s investment and the period in which they occur. Under this method of valuation, it is assumed that cash inflows occur at the end of the financial year while cash outflows occur at the beginning of the financial year.

Valuing a company using discounted cash flows uses a concept based on a financial principle that company’s value is determined by its ability to produce adequate cash flows for its financiers. This is why free cash flow is used since not all the cash flows to the company are entitled to the financiers of the company. Some of them are committed elsewhere in pursuit of the main objectives and goals of the company. This type of cash flow is available to all financiers of the company and is not affected by a company’s capital structure. The method focuses on generation of cash flows and the accounting assumptions and practices do not have much impact on cash flow. In addition, the method is more preferred since it looks into the future as opposed to relying on historical data which is a mere analysis of past information that might not hold true in the present.

**Introduction**

When assessing the value of a company, the question that confronts the valuer is whether the company should identify and discount cash payments and receipts and whether it should discount the profits that arise from the investment of the company. This is a very crucial consideration because cash flows from the company in a particular period of time will very rarely equal the accounting profit for the company during the same period. This is because the company’s profit is based on an accounting concept of income and expenditure relating to a particular accounting period based on the matching principle. This means that income receivable and expenses payable, but not yet received or paid, along with depreciation charges, form part of the profit calculations but are not recognized under cash flows.

Cash flow means financial staying power. It is a function of products, their market appeal and the sales turnover. Cash flow is an important criterion in company’s valuation because it makes the difference between the solvency of a company in the short run and contributes to its financial freedom from loan and indebtedness in the long run. This means that a company that assesses its valuation using the enterprise discounted cash flow method must have exhibited proper cash flow management for a long time it has been in business. This is true because cash flow directly affects the bottom line of every company. Inherently slow cash management operation cannot aid in profit maximization and would lead to exposing the company to a number of financial risks including bankruptcy or insolvency. Most financial problems involve cash flows occurring at different points in time. These cash flows have to be brought to be brought to the same point in time for the purposes of comparison and aggregation. There are many reasons for discounting the enterprise cash flows.

Any business undertaking is as well seen as a risk venture, which means you cannot preclude the element of risk in a company. This is because of the element of uncertainty with regard to receipt of the said cash flows. The bird in hand principle of financial management has an implication that a dollar at present time is certain whereas a dollar next year (future time) is lees certain to receive. This then brings us to the time value of money and hence the principles behind valuation of a company using the enterprise discounted cash flows. Money or cash flow has time value and a dollar receipt today is worth more than a dollar receipt at the end of the year. This is because of the general preference for current consumption to future consumption among individuals. Furthermore, capital can be employed productively to generate positive returns. An investment of a dollar at the start of this year will grow to (1+i) at the end of the year. In addition, during an inflationary period the amount of dollars today represent a greater purchasing power than the same amounts of dollars at the end of the year.

**Question 1**

**Determination of the cost of equity**

Companies often use a mixture of debt and equity to raise capital. The ratio of debt to equity can influence the present value and estimations of future cash flows. Capital structure represents the relationships among the different types of long term capital (Altman, 1984). When determining the capital structure of a firm, short term sources of finance and depreciation funds are ignored due to their short term period to maturity. Therefore, the components of the capital structure of a firm will mainly consist of equity capital and debt capital. The assets of the firm can be financed either by increasing owners’ claim or the creditors’ claim. The ownership claim is increased when the firm raises fund by raising ordinary shares or by retaining the earnings. The creditors’ claim is increased by borrowing. Hilton (2004) asserts that the various means of financing represents the financial structure of the company. The optimal leverage maximizes the value of the firm and equates the marginal gain from leverage to the marginal expected loss from bankruptcy costs (Myers, 1977). An optimal leverage can exist resulting from a trade-off between the expected costs of bankruptcy and the tax savings. Essentially, the optimal debt-equity mix is attained when the present value of the tax subsidy is just offset by the present value of the expected bankruptcy costs. A change in the percentage of debt in the capital structure of the firm has both positive and negative effect on the market value of the firm.

The common method for selling equity in the firm is to sell shares of stock. Selling equity provides the advantage that dividends are based on profitability. The disadvantage of selling stock is that shareholders will expect a continuous return on their investment and can sell off stock that fails to meet expectations. Stock sell-offs force a devaluation of the company.

Ordinarily, when calculating the WACC, the proportion of the company’s common
stock equity in the capital structure is multiplied by either the cost of
retained earnings or the cost of the new common stock. The specific cost used in
the common stock equity depends on whether the company’s equity financing will
be obtained using retained earnings or new common stock (Brigham and Ehrhardt,
2009). In the case of Henkel equity financing is purely on issuing shares.

**1 a) Risk free rate**

In determining the risk free rate we use a 10 year bond since it has the
least risk. This is because Government securities are most secure. We choose
3.38, because inflation needs time to be established; moreover, it is more
representative. Longer bond, gives you a bigger picture. Wider range for
comparison, for instance 2 years or 5 years is too short to tell. On the other
hand 20 years is too long.

Calculation for treasury rate = (4.52 + 4.74) / 2 = 4.63

Therefore, the most appropriate treasury rate to use in valuing the company’s cost of equity is 4.63. This is interpolated between 4.52 and 4.74. This decision is reached by considering the rating of Henkel AG. Its rating is A- which is rated between A and BBB+. Most debts in the capital structure of Henkel AG are expressed in terms of Euro. This means that the best treasury rate will be for bonds that are denominated in Euro. Therefore, you should use the Germany treasury since its bonds are denominated in Euro. Maturity is 10 years since most investors will invest in the company for a long time. Investors are usually classified into two major groups depending on their nature of investment motive. There are speculative investors and dividend minded investors. Speculative investors will commit their funds in the company for only a short time and sell off their shares when they think the stocks of the company are overvalued. The other category of investors will invest in the company for a long period in order to continue earning dividends out of the proceeds of the company. When calculating the cost of equity it is foreseen that investors will invest in the company to continue earning dividends and hence commit their funds in the company for a long period. This is the basis of choosing the maturity period to be 10 years. The interaction of this maturity and the rating from Euro denominated bonds results into Germany treasury rate of 4.63. This is the appropriate rate for using in valuing the cost of equity for the company given its current rating.

Calculation of beta for Henkel

Relevered beta for Henkel = 0.64 x (1+ 0.28) = 0.82

Therefore, Henkel’s corporate beta is 0.82 and the market risk premium is assumed to be 5%. Having all the information required to calculate the cost of equity, the estimation is done using the CAPM.

Therefore, cost of equity ke = Rf + Be(Mrp – Rf)

Where,

Rf = risk-free rate = 4.63%

Be = corporate beta = 0.82

Mrp = market risk premium = 5%

Hence, ke = 4.63% + 0.82*(5% – 4.63%) = 4.93%

An increase in the level of debt leads to tax savings, which decreases as the amount of debt increases since it raises the probability of bankruptcy, which in turn is determined by the choice of debt (Pratt, 2010). There is tax savings because the interest charged for debt loan is deducted first from the profit of the firm before corporate tax is determined. An increase in debt leads to an increase in the anticipated costs of bankruptcy. For a company to maximize its market value, it must minimize the costs associated with debt financing. In order to minimize the costs of debt financing, the proportion of debt capital in the capital structure of the firm should be maintained at a level such that it is not too low as to forego the tax savings and not too high to incur so much bankruptcy costs. Notice that when the level of debt capital in the capital structure is low an increase in debt causes a greater increase in tax savings than in bankruptcy costs thus increasing the value of the firm. However, a further increase in debt causes the probability of bankruptcy costs to increase hence lowering tax savings and raising the expected bankruptcy costs. This means an optimal; leverage will be attained when benefits of debt financing such as tax savings cancels out the costs of debt financing which is majorly bankruptcy costs.

The most appropriate treasury rate to use in valuing the company’s cost of debt is 3.56. This is interpolated between 3.46 and 3.67. This decision is reached by considering the rating of Henkel AG. Its rating is A- which is rated between A and BBB+. Most debts in the capital structure of Henkel AG are expressed in terms of Euro. This means that the best treasury rate will be for bonds that are denominated in Euro. Therefore, you should use the Germany treasury since its bonds are denominated in Euro. Maturity is 5 years since it is the ordinarily for Henkel AG not to carry a bond whose maturity is beyond 5 years. A shorter term of the bond is not appropriate for the company since it will be required to repay the debt before it has maximized its utilization in the company. It would also land the company into financial problems if it is required to pay back the debt and the company has not yet stabilized. On the other hand a long maturity will be an excess burden for the company since it has to meet the periodic interest payment for a long time. Moreover, long periods will attract a corresponding increase in treasury rate. This is because; risk is also related to time in that the longer the duration for debt repayment, the higher the chances of defaulting on debt repayment. The interaction of this maturity and the rating from Euro denominated bonds results into Germany treasury rate of 3.56. This is the appropriate rate for using in valuing the company’s cost of debt given its current rating.

A default premium of 0.11 is added after considering the rating for rating for the immediate rating. It should be noted that the rating increase downwards, which points that as the company creditworthiness gets poorer, the risk of defaulting on debt repayment increases correspondingly. Therefore, a company risk of defaulting is closely linked with the immediate linked. This means that if the company defaults its rating will drop down. Therefore, the rating of an A- company will drop to a BBB+ rated company. Hence the default premium should be equal to the difference in the rating. Therefore, the resultant rate is 3.67. The marginal tax rate for Henkel AG is 30%. This is the rate at which the company’s income is charged for tax purposes.

**Question 2**

**Determination of the cost of debt**

The cost of debt capital (bonds) is the interest that has been paid on it. In the case of debt capital, the effective cost is taken to consideration for the purpose of calculating the WACC. Since interest on debt is an expense allowed for tax purposes, it reduces the profit of the company that is subjected to corporate taxation. Therefore, the effective cost of debt capital will be the actual cost less tax benefit.

The actual cost of Henkel AG debt = 3.67%*61,267 = 2,248

Tax benefit = 30%*2,248 = 675

Effective cost of the debt = actual cost – tax benefit = 2,248 – 675 = 1,573

Therefore, effective rate = 1,573/61,267 = 3.241%.

The cost of capital is a dynamic concept affected by a variety of economic and company’s factors. When formulating the required rate of return, the key assumptions relating to risk and taxes are;

Business risk – the risk to the company of being unable to cover operating costs is assumed to remain unchanged. This assumption means that the acceptance of a proposed investment by the company leaves its ability to meet its operating costs unchanged (Weygandt, et al., 2009).

Financial risk – the risk to the company of being unable to cover the required financial obligations, for instance, interest, lease payment and preferred stock dividend is assumed unchanged. This assumption means that the projects are financed in such a way that the company’s ability to meet the required financing cost is unchanged (Aaker and McLoughlin, 2010).

After-tax costs are also considered relevant. The cost of capital is measured on and after tax basis.

The WACC calculates the cost of capital based on the percentage of debt and equity in raising capital. It is found by weighting the cost of each specific type of capital by its proportion in the first capital structure. WACC is calculated after the cost of the specific source of financing has been determined. This calculation is performed by multiplying the specific cost of each specific type of capital by its proportion in the first capital structure and summing the weighted values. To do this the following equation is used

WACC = (D/(D+E) * K_{D}) + (E/(D+E) * K_{E})

Where;

D/(D+E) = proportion of debt capital = 0.75

E/(D+E) = proportion of equity in capital structure = 0.25

K_{D} = after-tax cost of debt

K_{E} = cost of equity as estimated using the CAPM model = 4.63%

Therefore, WACC = (3.38 + 0.82*5) + 0.7 * 4.63% = 7.53 + 3.241 = 10.771%

All capital structure components must be accounted for. The resultant figure is the minimum returns that must be earned by the company in order to leave the company’s market value unchanged. It is the opportunity cost of capital, which is appropriate as discounting rate that the company should use to find the values of cash flows in order to make related company decisions (Martin and Titman, 2008).

Having determined the WACC as 10.771%, we will then use this figure as the appropriate discount rate to discount all the cash flows that are projected to emanate from the company. In determining the value of Henkel AG using the company discounted cash flows we will make certain assumptions to help in achieving this objective. Notice that under this method of valuation, the discount rate is required, which we have determined, and the cash flows. In addition, the period for which these cash flows will stream in the company is required to be known. We will take it as given that Henkel AG is a going concern. The assumption made under this method is that cash flows will stream to the company for infinity, which means it upholds the going concern concept of the business. Although accountants do not believe that a company will last indefinitely. They do expect it to last long enough to fulfil its objective and commitments. The assumption of continued existence provides logical bases for recording probable future economic benefits, for instance, cash inflows, and probable future outlays such as liabilities.

We noted earlier in this discussion that the accounting profit is not equal to the cash flow into the company. The accounting profit is determined from the revenue of the company. Consequently, the revenue generate will not be equal to the cash receipt in the company. Notice that the revenue for the company constitutes both cash sales and credit sales by the company. The credit sales are reported as the accounts receivables in the financial statements of the company. The cash receipts are the real cash inflows into the business. In this paper Henkel AG will be valued using its free cash flows. Therefore, the free cash flow of the company, as established from the consolidated cash flow statement for fiscal year 1999 is 1,462. It is assumed that there will be a constant flow of a similar amount every year. Therefore, this free cash flow will form an annuity to infinity, which will be discounted at 10.771% (the enterprise discount rate). The following formula is used to compute the discounted value for an annuity to infinity

CF.a_{∞} = CF/i

Where, CF = cash flow, a_{∞ }= annuity to infinity and i = the discount
rate

Therefore, the value of Henkel AG = 1,462/0.10771 = 13,573.48

**Conclusion**

The lenders of debt capital are legally entitled to interest and principal payments. Failure to meet these financial obligations the firm’s creditors can result to formal bankruptcy and the related costs can exceed the benefits obtained from the use of debt financing and reduce the company’s market value (Brigham and Houston, 2009). Therefore, the optimal leverage will depend on the amount of debt in a capital structure of a company, which minimizes the cost of capital for the firm and thus maximize its market value.

In a wider context it implies that when determining the optimal debt-equity mix of a company’s capital structure, the firm will first use its debt financing up to its optimum level then the remainder of the funds is topped up through equity capital. A firm can borrow as much as it wants provided there are enough assets to back up the debt finance. Therefore, for a firm to maximize the wealth of its shareholders, it should borrow upto its optimal leverage instead of maximizing its borrowing capacity. In fact, evidence show that firms with higher growth opportunities in their investment opportunity sets have low debt levels in their capital structure.

Valuing a company using discounted cash flows relies heavily on company’s expectations rather than the forces of the market and its approach is theoretical and relies on several assumptions. This forms the major limitation of this method of company valuation. Other shortcomings of this method are discussed hereunder.

The accuracy of this method depends heavily on the quality of assumptions made about the future cash flows and the discount rate. It is assumed that the company is a going concern hence the result may not hold to be true if the company is liquidated in the near future. The company operates from across the globe hence its cash flows are most likely to be affected by the currency exchange rates which is exogenous factor to the company. If the general inflation rate changes, then the projected cash flow will not be true since the discount rate is not adjusted to cushion for inflation.

References

Aaker, D. A., and McLoughlin, D., 2010. Strategic market management: Global
perspectives. 8^{th} ed. Australia: John Wiley and Sons.

Altman, E. I. 1984. A further empirical investigation of the bankruptcy cost
question. *Journal of finance*, 39, pp. 1067-1089.

Brigham, E. F., and Houston, J.
F., 2009. *Fundamentals of Financial Management*.
New York: Cengage Learning.

Hilton, R. W., 2004. *Managerial Accounting: Creating Value in a Dynamic
Business Environment*.
New Delhi: McGraw-Hill Publisher.

Martin, J. and Titman, S., 2008. Single vs. Multiple Discount
Rates: How to limit “Influence
Costs” in the Capital Allocation Process. *Journal of Applied Corporate
Finance, *20(2).

Myers, S. C. 1977. Determinants of corporate borrowing. *Journal of financial
economics*, 39, pp.575-592.

Pratt, J., 2010. *Financial Accounting in an Economic
Context*. New York: John Wiley and Sons.

Weygandt, J. et al., 2009. *Managerial Accounting: Tools for Business Decision
Making*. New York: John
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