Unit 2: Corporate valuation
Strategic Financial Management notes · PTU syllabus (MCOP302-18)
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Unit summary
Valuing the whole company is central to strategy, M&A and investor relations. This unit covers corporate valuation approaches — Marakon, Alcar, McKinsey and DCF (FCFF and FCFE) — MVA and EVA, implications for shareholder value, valuation of long-term investment decisions, sensitivity analysis, risk-adjusted discount rates, modified IRR and real options.
After this unit you can
- Explain the Marakon, Alcar and McKinsey approaches to valuation
- Value a firm using FCFF and FCFE
- Compute EVA and MVA and explain their implications
- Apply sensitivity analysis, RADR, MIRR and real options to investment decisions
PTU syllabus topics
- Models and approaches to corporate valuation — Marakon
- Alcar
- McKinsey and DCF (FCFE/FCFF) approaches
- MVA and EVA approaches
- shareholder value creation implications
- valuation of long-term investment decisions
- sensitivity analysis
- risk-adjusted discount rates
- modified IRR and real options
FCFF
EBIT (1 − t) + depreciation − capex − change in working capital
FCFE
FCFF − interest (1 − t) + net borrowing
EVA
NOPAT − (WACC × capital employed)
MVA
Market value of firm − capital employed
Gordon growth value
P0 = D1 / (Ke − g)
Topic 1
Approaches to corporate valuation
Marakon approach
Value created when ROE exceeds cost of equity, sustained with growth
Market-to-book ratio = (ROE − g) ÷ (Ke − g)
Alcar (Rappaport) approach
Value from seven value drivers via DCF
Shareholder value = Corporate value − Debt
McKinsey approach
Value from ROIC, growth and WACC; value-based management across the organisation
Economic profit = Invested capital × (ROIC − WACC)
Stern Stewart
Economic profit after full cost of capital
EVA and MVA
Topic 2
DCF valuation: FCFF and FCFE
Dividend valuation (constant)
P0 = D ÷ ke
Dividend growth model
P0 = D0 (1 + g) ÷ (ke − g)
Growth estimate
g = b × r (retention × return on equity)
Free cash flow to firm
EBIT (1 − t) + Depreciation − Capital expenditure − Increase in working capital
Enterprise value (DCF)
Σ FCFF ÷ (1 + WACC)^t + Terminal value ÷ (1 + WACC)^n
Terminal value (Gordon)
FCFF(n+1) ÷ (WACC − g)
Equity value
Enterprise value − Net debt
Example
D0 = ₹4, g = 6%, ke = 14%: P0 = 4 × 1.06 ÷ 0.08 = ₹53.
- DCF is theoretically the most sound; sensitive to WACC, growth and terminal value assumptions.
Free cash flow to equity
Net income + Depreciation − Capex − Increase in working capital + Net borrowing
Equity value (FCFE)
Σ FCFE ÷ (1 + Ke)^t + Terminal value ÷ (1 + Ke)^n
Topic 3
EVA and MVA
Economic Value Added
EVA = NOPAT − (WACC × Capital employed)
NOPAT
EBIT × (1 − t)
Market Value Added
MVA = Market value of equity (and debt) − Capital invested
Link
MVA = PV of future EVAs
Example
EBIT ₹200 crore, tax 25%, capital employed ₹1,000 crore, WACC 12%. NOPAT = ₹150 crore; capital charge = ₹120 crore; EVA = ₹30 crore — the firm created value this year.
- Implications: EVA aligns managers with shareholders (bonus banks), discourages over-investment, highlights the cost of equity; limitations: accounting adjustments, short-term focus, size bias.
Topic 4
Valuation of long-term investment decisions: sensitivity and RADR
- Sensitivity analysis: how much a key variable (sales volume, price, cost, discount rate) can change before NPV becomes zero.
Sensitivity margin (%)
NPV ÷ PV of the cash flow affected by the variable × 100
Example
NPV ₹20 lakh; PV of sales revenue ₹200 lakh → sales can fall by 10% before NPV = 0 — a highly sensitive variable.
- Limitations: changes one variable at a time; no probabilities.
- Risk-adjusted discount rate (RADR): add a risk premium to the discount rate for riskier projects; or use project-specific beta via CAPM (adjusting for gearing — asset beta and equity beta).
Asset (ungeared) beta
βa = βe × E ÷ [E + D (1 − t)]
Re-geared equity beta
βe = βa × [E + D (1 − t)] ÷ E
- Certainty equivalent approach: convert risky cash flows into certain equivalents and discount at the risk-free rate.
Topic 5
Modified IRR and real options
- MIRR assumes intermediate cash flows are reinvested at the cost of capital (not at IRR) and avoids multiple IRRs.
MIRR
(Terminal value of inflows compounded at k ÷ PV of outflows)^(1/n) − 1
Example
Outlay ₹1,000; inflows ₹500, ₹500, ₹500; k = 10%. Terminal value = 500 × 1.21 + 500 × 1.1 + 500 = 1,655. MIRR = (1,655 ÷ 1,000)^(1/3) − 1 ≈ 18.3% (IRR ≈ 23.4%).
- Real options: management flexibility valued like financial options — option to expand, abandon, delay (timing), switch inputs/outputs; strategic NPV = static NPV + value of options; valued with decision trees or Black–Scholes/binomial models.
Key terms
- FCFF
- Cash flow available to all capital providers
- FCFE
- Cash flow available to equity shareholders after debt flows
- EVA
- NOPAT minus a charge for capital at WACC
- MVA
- Market value minus capital invested
- Real option
- Value of managerial flexibility in investment projects
Quick revision
- Marakon (ROE vs Ke), Alcar (value drivers), McKinsey (ROIC vs WACC).
- FCFF at WACC → enterprise value; FCFE at Ke → equity value.
- EVA = NOPAT − WACC × capital; MVA = PV of EVAs.
- Sensitivity, RADR, scenario, simulation.
- MIRR reinvests at k; real options add strategic value.
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.What is the Marakon approach?
- Q2.Distinguish FCFF and FCFE.
- Q3.Define EVA.
- Q4.What is MVA?
- Q5.Why is MIRR preferred over IRR?
- Q6.Name four types of real options.
Long-answer questions
- Q1.Explain the Marakon, Alcar and McKinsey approaches to corporate valuation.
- Q2.Explain DCF valuation using FCFF and FCFE.
- Q3.Explain EVA and MVA and their implications for shareholder value.
- Q4.Explain the techniques of evaluating risky long-term investment decisions including MIRR and real options.
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