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Flinder Valves and Controls Inc.

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rP os t

Rev. Feb. 24, 2009


op yo This note addresses the methods used to value companies in a merger and acquisitions
(M&A) setting. It provides a detailed description of the discounted-cash-flow (DCF) approach and reviews other methods of valuation, such as market multiples of peer firms, book value, liquidation value, replacement cost, market value, and comparable transaction multiples.
Discounted-Cash-Flow Method


The DCF approach in an M&A setting attempts to determine the enterprise value or value of the company, by computing the present value of cash flows over the life of the company.1 Because a corporation is assumed to have infinite life, the analysis is broken into two parts: a forecast period and a terminal value. In the forecast period, explicit forecasts of free cash flow that incorporate the economic costs and benefits of the transaction must be developed.
Ideally, the forecast period should comprise the interval over which the firm is in a transitional state, as when enjoying a temporary competitive advantage (i.e., the circumstances where expected returns exceed required returns). In most circumstances, a forecast period of five or ten years is used.


The terminal value of the company, derived from free cash flows occurring after the forecast period, is estimated in the last year of the forecast period and capitalizes the present value of all future cash flows beyond the forecast period. To estimate the terminal value, cash flows are projected under a steady-state assumption that the firm enjoys no opportunities for abnormal growth or that expected returns equal required returns following the forecast period.
Once a schedule of free cash flows is developed for the enterprise, the weighted average cost of


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