Asset Valuation in Finance

There are nine theories and ten methods for valuation. The valuation of any asset is a highly subjective one and depends on hosts of factors, some beyond the control of buyer or seller. This picture captures some of the essence of valuation.

The nine theories are

1. Fernandez (2007) assumes that the company will have a constant debt-to-equity ratio in book value terms. In this scenario, the risk of the increases of debt is equal to the risk of the free cash flow.
2. Miles and Ezzell (1980) assume that the company will have a constant D/E ratio in market value terms: the correct discount rate for the tax shield (D Kd T) is Kd for the first year, and Ku for the following years.
3. Modigliani and Miller (1963) assume that the amount of debt of every future year is known today and discount the tax savings due to interest payments at the risk-free rate (RF).
4. Myers (1974) makes assumptions similar to those of Modigliani and Miller (1963) and discounts the tax savings due to interest payments at the required return to debt (Kd).
5. Miller (1977) concludes that the leverage-driven value creation or value of the tax shields is zero.
6. Harris and Pringle (1985) and Ruback (1995) discount the tax shields at the required return to the unlevered equity (Ku). According to them, the value of tax shields (VTS) is VTS = PV[D Kd T ; Ku].
7. Damodaran (1994). To introduce leverage costs, Damodaran assumes that the relationship between the levered and unlevered beta is:  βL = βu + D (1-T) βu / E (Instead of the relationship obtained in Fernandez (2007), βL = βu + D (1-T) (βu - βd) / E).
8. Practitioners method. To introduce higher leverage costs, this method assumes that the relationship between the levered and unlevered beta is: βL = βu + D βu / E.
9. With-cost-of leverage. This theory assumes that the cost of leverage is the present value of the interest differential that the company pays over the risk-free rate.

The ten methods are

1. equity cash flows discounted at the required return to equity;
2. free cash flow discounted at the WACC;
3. capital cash flows discounted at the WACC before tax;
4. APV (Adjusted Present Value);
5. the business’s risk-adjusted free cash flows discounted at the required return to assets;
6. the business’s risk-adjusted equity cash flows discounted at the required return to assets;
7. economic profit discounted at the required return to equity;
8. EVA discounted at the WACC;
9. the risk-free rate-adjusted free cash flows discounted at the risk-free rate; and
10. the risk-free rate-adjusted equity cash flows discounted at the required return to assets.

But valuation of asset is a highly subjective. There can never be generalizations. Value depends on the

1. Demand and supply
2. Urgency to buy or sell
3. Behavior of seller and buyer
4. One’s forecast of future events
5. One’s future planning
6. Cash flows and discount rates