1. Describe the various constraints of the valuation faced by New Grade.
The constraints of the various methods are that the valuation model used for valuation has some of its limitations and acceptance. The limitations are defined below in detail.
Free cash flow method:
The free cash flow method is widely used and accepted method of valuation, but it has certain limitations that affect its acceptability assurance.
- The first limitation of the free cash flow method is that the time period is considered to be very long and it is not possible to estimate the cash flows for a too long period. In this case 18 years cash flows are estimated. Also, it is not possible that all cash flows occur in the manners these are estimates.
- The required return is derived through the weighted average cost capital (WACC). The WACC of the company is valued through the current required return of the shareholders and debt holder with the current ratio of debt and equity. It is possible that the ratio and the return can change due to change in any variable that can change the required return of the firm and affect the valuation of the company and estimations fails. For large tenor, it may not be possible that the required return of all the investors remain same for 18 years of tenure.
- The company may not meet the going concern assumption for many years. It is not possible in every case that the company’s survival is possible for 18 years, any of the economic conditions can hit its going concern assumption and the company can shut down its operations before 18 years. In this case, it is estimated that the company can survive for 18 years of time.
Market comparable:
In market comparable method, it is considered that the company’s valuation aligns with those companies under consideration to get the market multiplied for valuation purpose. The companies that estimated the EBITDA method of market multiple valuation may not be of the same size and may not be working under the same condition as the target company is facing the conditions. The company may use its own techniques to grow in the business and the techniques may not match, some of them have a good management control and some do not have such good management controls. Therefore, on the basis of market values in the stock exchange and profitability, assumptions cannot be based for right valuation.
The companies listed under stock exchange provide audited reports, therefore the EBITDA can be assumed that it ah reasonable basis to believe that the reports are free from any material misstatement. The stock market limitation cannot be ignored in this case where the prices are manipulated on the basis of its performance and the interest of the investors over the stock price. This largely affects the EBITDA market multiple method.
Precedent transactions:
In preceding transaction method, it is assumed that the price over cash flows of past transactions average is considered to be a reasonable valuation multiplier to value a business. In the past, there were many transactions that took place during different period and different business cycles, to base the assumptions that the precedent sales method is best measure to value the business. The bargaining power and attractiveness of the company differ from company to company and its market position. The bases do not seem to be reasonable to value the business through only this method with a view that the value is fair value for the target company.
2. Describe the calculation underlying the Free Cash Flow to the Firm Method utilizing.
The value of the firm through free cash flow method is considered to be the value of the debt and equity. The value is considered to be the value of the company as a whole. It can be said that the total assets of the company or total liability and equity of the company is the value of the firm. It is further discussed in the net parts of the case.
a. The Value of the Firm using Free Cash Flow
The value of the firm through its future expected cash flows is $1,741.8 million. The value of the business is simply the total of free cash flows for the year 2008 till 2025 (Appendix 4). The value is considered for the business that has the potential to earn the above specified amount in the period of 18 years in cash term. The free cash flow is considered to be the net cash remaining in the firm after meeting its operating and investing cash flows. The investment cash flows are not considered for the free cash flow calculation...........................
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