Discounted cash flow (DCF) approach is theoretically the most appropriate valuation approach. The value of a firm depends on the expected cash flows and the discount rate. The expected cash flow of the firm depends on the operating efficiencies and market conditions.
The discounted rate depends on the risk of the expected cash flows. Firm’s generating specify target capital structure in terms of fixed debt-to-value ratio. In conculsion, Wacc is the appropriate discount rate for valuing a firm.
To estimate a continuation value in year T using discounted cash flow. We assume a constant expected growth rate and constant debt-equity ratio.
FCF=free cash flow
= weighted average cost of capital(WACC)
If FCF remains constant forever, that is FCF is a perpetuity, the value of the firm
Earnings are the basics for estimating fre cash flows of firm cash flows include an adjustment for depreciation, capital expenditure and working capital.
Earning depends on capital
If we assume constant relation of earnings depends on sales.If we assume constant relation of earnings working capital and capital expenditure to sales.
T=Corporate tax rate
w=net working capital