Question & Answer: How does the valuation of a firm vary from the valuation of a project using WACC?…..

How does the valuation of a firm vary from the valuation of a project using WACC?

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a. The WACC must be set equal to RM when valuing a firm

b. A terminal value is included in the valuation process for a firm but generally not for a project

c. Book values are used as the weights for WACC when valuing a firm

d. Debt and equity weights are set equal for WACC when valuing a firm

e. Debt is not adjusted for taxes when computing the WACC for a firm valuation

Expert Answer

 

Answer:

b. A terminal value is included in the valuation process for a firm but generally not for a project.

For project valuation the cash flows are computed for the life of the project and those cash flows are discounted to get the value.

In the case of valuation of a firm as a whole, the cash flows are projected for a period that is reasonably predictable called ‘horizon period’. Beyond that point and into infinity, a constant growth rate of cash flows is assumed. Using this growth rate and the required return, the value of the expected cash flows beyond the predictable period is found out by using the formula for a growing perpetuity. The value so obtained is called the terminal value. Like the cash flows in the predictable period, this terminal value is also discounted to get the total PV of cash flows from t0 to infinity.

The calculation of terminal value is the distinguishing feature of valuation of a business.

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