![]() ![]() Application of the discounted cash flow methodology Introduction Instead, it needs to be adjusted throughout the valuation period to reflect the changes in the capital structure. However, since the capital structure typically changes over time, the use of a constant WACC may not be appropriate. It is often used applying a constant discount rate, which would require a stable capital structure (i.e., a constant ratio of the market value of debt to the market value of equity). The weighted average cost of capital (WACC) approach is the most commonly used enterprise valuation approach. The equity value can be derived from the enterprise value by deducting the market value of non-equity claims (i.e., primarily interest-bearing debt). The enterprise valuation approach calculates the enterprise value of the business through discounting the future net cash flows before debt payments and after reinvestment needs (known as ‘free cash flow to the firm’) at a rate reflecting the cost of all sources of capital, applying a blended cost of capital. The equity valuation approach calculates the value of equity by discounting the future net cash flows after debt payments and reinvestment needs (known as ‘free cash flow to equity’) at a rate reflecting only the cost of equity. Both approaches are broadly accepted but vary with regard to the relevant cash flows and discount rates. The DCF method distinguishes two general approaches, depending on whether the value is determined for only the equity investment in the business (known as ‘equity valuation approach’) or the entire business (known as ‘enterprise valuation approach’). It is, therefore, less prone to manipulation through the use of accounting policies and avoids divergent results from the use of different accounting principles (e.g., International Financial Reporting Standards (IFRS), United States Generally Accepted Accounting Principles (US-GAAP)). Within the different approaches applied for valuing a business, it ‘comes with the best theoretical credentials’ and ‘remains a favourite of practitioners and academics because it relies solely on the flow of cash in and out of the company, rather than on accounting-based earnings’. The DCF methodology determines the business value as the present value of expected future net cash flows discounted at a rate reflecting the time value of money and the risks attributable to these cash flows. ![]() ![]() Discounted cash flow methodology Introduction The following sections briefly introduce the discounted cash flow (DCF) methodology and its approaches, and then discuss, in the context of international arbitration, its application to the assessment of damages, the assumptions required to adequately and reliably use this methodology and the documentation required to support its results. Since the requirement of full compensation is generally interpreted to put the damaged party into the same economic (i.e., financial) situation it would have been in but for the wrongful act, the methodology and approaches widely accepted for business valuation are also applied in the determination of damages. When applying the income approach, the theory of business valuation determines the value of a business by assessing the present value of its future net cash flows.
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