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1 Valuation: Cash Flow- Based Approaches Dr. Nancy Mangold California State University, East Bay

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2 Valuation zSecurity Analyst and Investment Bankers zMake buy, sell, or hold recommendations zRight Price for IPO zPrice for a corporate acquisition

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3 Valuation zEconomic Theory zValue of any resource equals the present value of the returns expected from the resource, discounted at a rate that reflects the risk inherent in those expected returns

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4 Valuation

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5 Rationale for Cash-Flow Based Valuation zCash is the ultimate source of value zCash serves as a measurable common denominator for comparing the future benefits of alternative investment opportunities

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6 Cash Flow vs Earnings zInvestors cannot spend earnings for future consumption zAccrual earnings are subject to numerous questionable accounting methods yPooling vs purchase in acquisition valuation yExpensing of R & D costs zEarnings are subject to purposeful management by a firm

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7 Cash Flows vs Earnings zEarnings are not as reliable or meaningful as a common denominator for comparing investment alternatives as cash z$1 earnings (Firm 1) not equal to $1 earnings (Firm 2). z$1 Cash (Firm 1) = $1 Cash (Firm 2)

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8 Cash Flow-Based Valuation zThree elements needed zExpected periodic cash flows zResidual (Terminal) value - Expected cash flow at the end of the forecast horizon zDiscount rate used to compute the present value of the future cash flows

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9 I. Periodic Cash Flows zCash Flow to the Investor vs Cash Flow to the Firm zCash Flow to the Investor: CF dividends expected to be paid to the investor zCash Flow to the Firm (CF dividends + CF retained by firm) zIf the rate of return of retained CF equals the discount rate, either CF will yield the same valuation zUse Cash Flow to the Firm

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10 Periodic Cash Flows: Relevant Firm Level Cash Flows zWhich cash flow amounts from the projected statement of cash flows the analyst should use to discount to present value when valuing a firm zUnleveraged free cash flows zleveraged free cash flows

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11 Periodic Cash Flows: Relevant Firm Level Cash Flows zUnleveraged free CF is CF before considering debt vs equity financing zUnleveraged free cash flows = CFO + interest cost (net of tax) +(-) Cash flow for investing activities zThis pool of cash flows is available to service debt, pay dividends and provide funds to finance future earnings

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12 Leveraged free cash flows zLeveraged free cash flows = CFO - Cash flow for investing activities +(-) net change in ST & LT borrowing +(-) Changes and dividends on on preferred stock zCash flows available to the common shareholders after making all debt service payments to the lenders and paying dividends to preferred shareholders

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13 Measurement of Unleveraged and Leveraged Free Cash Flows zUnleveraged Free CF zCash Flow from Operations before subtracting Cash outflows for interest costs (net of tax savings) z=Unleveraged CFO z+(-) CF for Investing Act. z= Unleveraged Free Cash Flow to All Providers of Capital z Leveraged Free CF z CFO before interest z - Cash outflows for interest costs (net of tax savings) z =leveraged CFO z +(-) CF for Investing Act. z +(-)CF for changes in ST< borrowing z +(-)CF for changes in and Dividends on preferred stock z = leveraged Free CF to Common Shareholders

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14 Unleveraged Free Cash Flows zIf the objective is to value the assets of a firm, then the unleveraged free cash flow is the appropriate cash flow zDiscount rate should be weighted average cost of capital

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15 Leveraged Free Cash Flows zIf the objective is to value the common shareholders’ equity of a firm, then the leveraged free cash flow is the appropriate cash flow zDiscount rate should be the cost of equity capital

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16 Unleveraged vs Leveraged Free Cash Flows zThe Valuation Difference = the value of total interest-bearing liabilities and preferred stock

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17 Unleveraged vs Leveraged Free Cash Flows zValue interest-bearing liabilities by discounting debt service costs (including repayments of principal) at the after tax cost of debt capital

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18 Unleveraged vs Leveraged Free Cash Flows zValuing preferred stock by discounting preferred stock dividends at the cost of preferred equity

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19 Unleveraged vs Leveraged Free Cash Flows zValuation for total assets (unleveraged Free CF) = zValuation for common equity (leveraged Free CF) z+ Value of interest-bearing liabilities z + Value of preferred stock

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20 Acquiring the operating assets of of another firm zAcquiring firm will replace with its own financing structure zPrice to pay for the division’s assets?

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21 Acquiring the operating assets of of another firm zCF these assets will generate zUse unleveraged free cash flows (Operating cash flows - cash outflow for investing) zDiscount these projected cash flows at the weighted average cost of capital of the new division

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22 Engage in a leveraged buy out (LBO) of a firm zManagers offer to purchase the outstanding common shares of the target firm at a particular price if current shareholders will tender them zThe managers invest their own funds for a portion of the purchase price (usualy 20% - 25%) and borrow the remainder from various lenders

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23 Engage in a leveraged buy out (LBO) of a firm zThe managers use the equity and debt capital raised to purchase the tendered shares zAfter gaining voting control of the firm, the managers direct the firm to engage in sufficient new borrowing to repay the bridge loan obtained to execute LBO

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24 Engage in a leveraged buy out (LBO) of a firm zThe lenders have a direct claim on the assets of the firm zManagers shift any personal guarantees they made on the bridge loans to the firm

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25 Price of LBO zUse Valuation of common equity zLeveraged free cash flows discounted at the cost of common equity capital

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26 Price of LBO zOr Use Valuation of total assets and subtract the market value of the debt raised to execute the LBO. zPV of unleveraged free cash flows using the weighted average cost of debt and equity capital

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27 Price of LBO zThe projected debt service costs after the LBO will differ significantly zValuation of the equity must reflect the new capital structure and the related debt service cost zThe cost of equity capital will increase as a result of the higher level of debt in the capital structure

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28 Nominal Vs Real Cash Flows zNominal cash flows include inflationary or deflationary components zReal cash flows filter out the effect of changes in general purchasing power zValuation should be the same whether one uses nominal cash flow amounts or real cash flow amounts, as long as discount rate used is consistent with CF

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29 Nominal Vs Real Cash Flows zIf projected cash flows ignore changes in the general purchasing power of the monetary unit zThen the discount rate should incorporate an inflation component zNominal CF1.15 million (land price) zDiscount rate s/b 1/1.02 /1.1 zInterest rate 2% and inflation rate 10% zValue102.5

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30 Nominal Vs Real Cash Flows zIf projected cash flows filter out the effects of general price changes zThen the discount rate should exclude the inflation component zReal CF1.15 million (land price)/1.1 (inflation rate) zDiscount rate s/b 1/1.02 zLand Value102.5

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31 Nominal Vs Real Cash Flows zA firm owns a tract of land that it expects to sell one year from today for 115 million zThe selling price reflects a 15% increase in the selling price of the land zGeneral price level is expected to increase 10% zThe real interest rate is 2%

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32 The Value of Land Discount rate including expected inflation 115m x 1/(1.02)(1.1)= 102.5 million Discount rate excluding expected inflation (115 million/1.10) x 1/1.02 = 102.5 million

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33 PreTax vs After-Tax Cash Flows zDiscount pretax cash flows at a pretax cost of capital zDiscount after-tax cash flows at an after- tax cost of capital zValuation will be the same

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34 Selecting a Forecast Horizon zFor how many future years should the analyst project periodic cash flows? zTheoretically: the expected life of the resource to be valued (machine, building ) zTo value the equity claim on the portfolio of net assets of a firm, the resource has indefinite life zAnalyst must project the years of CF and residual value at the end of forecast horiz.

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35 Selecting a Forecast Horizon zPrediction of CF requires assumptions for each item in the IS and BS and then deriving the related CF

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36 Selecting a Forecast Horizon zUsing a relatively short forecast horizon (3-5 years) enhances the likely accuracy of the projected periodic cash flows znear term cash flows is often an extrapolation of the recent past znear term cash flows have the heaviest weight in the PV computation zBut a large portion of the total PV will be related to the residual value

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37 Selecting a Forecast Horizon zThe valuation is difficult when near-term cash flows are projected to be negative in rapidly growing firm that finances its growth by issuing common stock zAll of the firm’s value relates to the less detailed estimation of the residual value

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38 Selecting a Forecast Horizon zSelecting a longer period in the forecast of periodic cash flows (10-15 years) zReduces the influence of the estimated residual value on the total PV zPredictive accuracy of detailed cash flow forecasts this far into the future is likely to be questionable

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39 Selecting a Forecast Horizon zIt is best to select as a forecast horizon the point at which a firm’s cash flow pattern has settled into an equilibrium zThis equilibrium position could be either no growth in future cash flows or growth at a stable rate zSecurity analysts typically select a forecast horizon in the range of 4-7 years

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40 II. Residual Value zResidual Value at end of Forecast Horizon = Periodic Cash Flow n-1 x 1+g r-g zWhere zn= forecast horizon zg= annual growth rate in periodic cash flows after the forecast horizon zr= discount rate

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41 Residual Value zLeveraged free cash flow of a firm in year 5 is 30 millions z0 growth expected zCost of equity capital = 15% zResidual value y= 30 x (1+0.0)/(.15-0.0) = 200 million zPV of RV (in Year 5)= 200 x 1/(1.15) 5 = 99.4 million

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42 Residual Value zAdd growth rate = 6% zResidual value = y30 x (1+0.06)/(.15-0.06) = 353.3 million zPV = 353.3 x 1/(1.15) 5 = 175.7 million

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43 Residual Value zAdd growth rate = -6% zResidual value = y30 x (1-0.06)/(.15 - (-0.06) = 134.3 million zPV = 134.3 x 1/(1.15) 5 = 66.8 million zAnalysts frequently estimate a residual value using multiples of 6-8 times leveraged free cash flows in the last year

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44 Difficulty in Using Residual Value zWhen the discount rate and growth rate are approximately equal zThe denominator approaches zero and zThe multiple becomes exceedingly large. zWhen the growth rate exceeds discount rate zThe denominator becomes negative, the resulting multiple becomes meaningless

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45 Alternative Approach to Estimate Residual Value zUse free cash flow multiples for comparable firms that currently trade in the market zthis model provides a market validation for the theoretical model zThe analyst identifies comparable companies by studying growth rates in free cash flows, profitability levels, risk characteristics and similar factors.

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46 III. Cost of Capital zThe analyst uses the discount rate to compute the present value of the projected cash flows zThe discount rate equals the rate of return that lenders and investors require the firm to generate to induce them to commit capital given the level of risk involved

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47 Cost of Capital zCost of debt capital equals the after-tax cost of each type of capital provided to a firm

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48 Cost of Debt Capital zCommon practice excludes operating liability accounts from weighted average cost of capital zThe present value of unleveraged free cash flows is the value of total assets net of operating liabilities which equals debt plus shareholders’ equity

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49 Cost of Debt Capital zThe cost of debt capital equals z(1- marginal tax rate) x yield to maturity of debt zThe yield to maturity is the rate that discounts the contractual cash flows on the debt to the debt’s current market value zThe yield=coupon rate if the debt sells at par(face) value

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50 Cost of Debt Capital zCapitalized lease obligation have a cost equal to the current interest rate on collateralized borrowing with equivalent risk

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51 Cost of Debt Capital zThe analyst should include the present value of significant operating lease commitment in the calculation of the weighted average cost of capital

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52 Cost of Debt Capital zIf the analyst treats operating leases as part of debt financing, then the cash outflow for rent should be reclassified as interest and repayment of debt in leveraged and unleveraged free cash flow

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53 Cost of Preferred Equity Capital zDividend rate on the preferred stock

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54 Cost of Common Equity Capital zCapital Asset Pricing Model (CAPM) zIn equilibrium, the cost of common equity capital equals the market rate of return earned by common equity capital

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55 Cost of Common Equity Capital zR(i) = R(f) + b (R(m) - R(i)) zCost of common equity = Interest rate on risk free securities + Market beta (Average return on the market portfolio - Interest rate on risk free securities)

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56 Cost of Equity Capital

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57 Risk Free Interest Rate zYield on LT US government securities zNot a good choice, the longer the term to maturity, more sensitive to changes in inflation and interest rates, greater systematic risk zCommon practice to use the yield on either short or intermediate-term US government securities as risk free rate zHistorically averaged around 6%

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58 Market Return zDepends on period studied zHistorically the market rate of return has varied between 9 and 13% zThe excess return over the risk free rate has varied between 3 and 7 percentage points

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59 Market Returns zFinancial reference sources publish market equity beta for publicly traded firms zStandard & Poor’s Stock Reports zValue Line, Moody’s zConsiderable variation in the published amounts for market beta among different sources due to period used to calculate the betas

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60 Adjusting Market Equity Beta zto Reflect a New Capital Structure zThe market equity beta computed using past market price data reflects the capital structure in place at a particular time zAnalyst can adjust this equity beta to approximate what it is likely to be after a change in the capital structure

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61 Adjusting Market Equity Beta zUnleverage the current beta zthen releverage it to reflect the new capital structure zCurrent leveraged equity beta = Unleveraged Equity beta [1+(1-income tax rate) ( Current market value of debt)/ current market value of equity)]

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62 Adjusting Market Equity Beta zEquity Beta = 0.9 zIncome tax rate =.35 zDebt/equity ratio =.60 zChange D/E ratio to 140% zUnleveraged equity beta x z0.9 = X [1+ (1 - 0.35) (0.60/1.0)] zX = 0.65

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63 Adjusting Market Equity Beta zReleveraged market beta zY = 0.65 [ 1 + (1- 0.35)(1.4/1.0)] zY= 1.24

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64 Evaluating the Cost of Equity Capital Using CAPM: Criticisms zMarket betas do not appear to be stable over time and are sensitive to the time period used in their computation zThe excess market rate of return is not stable over time and is likewise sensitive to the time period zFama and French suggests that during the 1980s size was a better proxy for risk than market beta

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65 Weights Used for Weighted Average Cost of Capital zShould use the market values of each type of capital zMarket value of debt securities is disclosed in notes to financial statements zMarket price quotations for equity securities provide the amounts for determining the market value of equity

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66 A Firm’s Capital Structure on Balance Sheet

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67 Cost of Capital zLT Debt z8% x (1-.35) = 5.2% zPreferred Equity z4% zCommon Equity z6% +.9 (13% - 6%) = 12.3%

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68 Weighted Average Cost of Capital

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69 Valuation of a Single Project zInvestment = 10 million zUnleveraged CF 2 million/year forever zFinancing6 million debt zFinancing4 million Common Equity zDebt interest rate 10% zTax rate 40% zCost of Capital 25.625%

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70 Value of Common Equity z Unleveraged Free Cash Flow 2,000,000 Interest paid on Debt.10*6,000,000 (600,000) Income Tax Savings on Interest.4*600,000 240,000 Leveraged Free CF1,640,000

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71 Value of Common Equity zThe value of the project to the common equity z1640000/.25625=6,400,000 zExcess over investment z6,400,000-4,000,000=2,400,000 zThe factor of PV of an annuity that last forever is 1/r

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72 Value of Debt + Equity zValue of Debt zAfter tax cost for debt is 6% z6% = (10% * (1-40%)) zThe common equity cost.25625%

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73 Value of Debt + Equity

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74 Value of Debt + Equity Type of Capital AmtWeightCostWeighted Average Debt6M.48387.06.02903 Common Equity 6.4M.51613.25625.13226 Total12.4 M 1.00.16129

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75 Value of Debt + Equity zPV (Debt + Equity) is z2,000,000/.16129 = 12,400,000 zSubtracting 6 million of debt zCommon Equity is 6.4 million

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76 Valuation of Coke Yr 8Yr 9Yr 10Yr 11Yr 12 CF from Operations 3,6103,7883,9744,1664,366 CF from Investing -1,198-1,390-1,534-1,691-1,866 CF from Debt Financing 1,0171,3551,6191,8351,988 Leveraged Free CF 3,4293,7534,0594,3104,488

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77 Year 12 Residual Value zThe analyst make assumption about net cash flows after year 12 zThe average compound growth rate of leveraged free CF between year 8-12 is 7%, assume it will remain at 7%

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78 Year 12 Residual Value zYr 7 market beta is.97 zRisk free rate = 6% zExcess Mkt Return over Risk Free Rate = 7% zCost of Equity Capital = z6% +.97(7%) = 12.8% z4,488 x 1+.07= $82,796 0.128 -.070

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79 Present Value YearCF12.8 Factor PV 83,429.886523,040 93,753.797192,992 104,059.696742,828 114,310.617682,662 124,488.547592,458 Aft 1282,796 (4488x(1.07/0.128-.07)).5475945,338 Total59,318

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80 Price per Share zprice per share z59,318 million/2,481 million shares = 23.91 zCoke’s market price in yr 7 = 52.63

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81 Price Difference zInaccurate projections of future cash flow zErrors in measuring the cost of equity capital zMarket inefficiencies in the pricing of Coke

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82 Advantages- Present Value of Cash Flow Valuation zFocus on cash flows zProjected amounts of CF result from projecting likely amounts of revenues, expenses, assets, liabilities and shareholders’ equity which require the analyst to think through many future operating, investing and financing decisions of a firm

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83 Disadvantages of the PV of Future Cash Flow Valuation zThe residual or terminal value tends to dominate the total value in many cases zThis residual value is sensitive to assumptions made about growth rates after the forecast horizon zThe projection of cash flows can be time consuming and costly when analyst follow many companies and identify under and overvalued firms regularly.

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