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Company value as EBIT(1-t)/r?

Just encountered that on my Wiley mock. Twice actually.

Have you seen it anywhere else? I gues you could say that EBIT after taxes is sort of an approximation of FCFF...but to use in an actual valuation and imply cost of equity from using it seems too far fetched to me.

Am I wrong?

Btw.: It's frustrating, but Wiley also isn't free of mistakes and errors. The most irritating and literally "gamebreaking" one for me is that binomial IR trees don't show in the vignette.

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Comments

  • mitch895mitch895 AustraliaPosts: 125 Jr Portfolio Manager
    @Prosper0, you're right, it does seem over-simplified.  

    From a logical point of view, the way I would think of this is that you're trying to value the business - what would you pay for it if you were buying the whole thing if you had cash.  In that case you wouldn't need to pay interest on any debt (so you ignore interest payments), so the appropriate estimate of Net Income would be EBIT less tax.  So that tells you how much you should expect to get from your investment, so then working out how much to pay for the investment is just a matter of comparing this against your required RoE.  

    So assuming EBIT of $100, no future growth, and a tax rate of 30%, the investment would potentially pay you $70.  If your required rate of return (Return on your Equity - RoE) you would pay $700.  

    I'm not 100% confident this is right though :neutral: 
  • This seems riddled with mistakes to me. Firstly EBIT(1-t) is not a very good approximation for FCFF in my opinion. Looking at the formulas:
    FCFF = NI + NCC + Int(1-t) - WCInv - FCInv
    And
    FCFF = EBIT(1-t) + Depreciation + WCInv + FCInv you have the Interest part covered with EBIT but you don't really have the WCInv and FCInv and Depreciation part covered and those are very vital components.

    Apart from this even if it was a good approximation for FCFF you can't directly derive the the cost of equity from FCFF because remember the Value of a Firm is FCFF divided by WACC not r. You could of course derive r if you knew the target weights and after tax cost of debt.

    I'm also a Level 2 candidate like you so please take my opinion with a pinch of salt. I can be wrong too.
  • I have come across this simple method of using EBIT as a proxy in Corp Finance only....specifically in the Modigliani-Miller proposition sections where you calculate the value of levered/unloved firms along with the cost of equity for varying capital structures. Never seen EBIT used in the Equity section.
  • Prosper0Prosper0 PraguePosts: 25 Sr Associate
    edited June 2015
    Right, so it is there...Ok, I guess i didn't note it down or pay too much attention to it. Thanks, though!
  • Yeah check out Modigliani-Miller proposition 2 from the CFAI Corp Finance text book, it is in that specific section :)
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