Cost of Capital: Applications and Examples, + Website, 5th Edition

APPENDIX 43A

Report for Cost of Capital for a Smaller-Sized Company

Section D—Income Approach

Discounted Cash Flow Method

Cash Flows to Equity

Discount Rate

Valuation Summary—Discounted Cash Flow Method

SECTION D—INCOME APPROACH

The income approach is based on the fundamental premise that the value of an asset is the present worth of the expected net cash flows generated by the asset over its expected life. The income approach requires an analysis of expected future revenue, expenses, working capital, capital expenditures, and debt principal, as well as an estimation of the required rate of return for an investment in the subject company. In the valuation of a controlling interest in a company's common stock, such a forecast attempts to reflect the expected returns a prospective buyer of a controlling interest in the company would expect.

There are two basic methods that can be used to estimate value under this approach: the capitalization method and the discounting method. Both are based on two very general steps: (1) the estimation of an asset's future economic earnings stream available to the interest holder and (2) the application of an appropriate risk-adjusted present value discount rate or capitalization rate to this earnings stream.

One method under the income approach is the discounted cash flow method (discounted economic income method or discounted net income method). Under this method, discrete forecasts for the chosen measure of economic income are made for a number ...