An analysis of discounted cash flow (DCF) approach to business valuation in Sri Lanka by Thavamani Thevy Arumugam Matriculation Number: 8029 This dissertation submitted to St Clements University as a requirement for the award of the degree of Doctor of Philosophy in Financial Management September 2007 Table of Contents Chapter 1 Introduction .............................................................................................5 1.1 Background.......................................................................................................5 1.1.1 wealth maximization ...............................................................................5 1.2 Concept of an investment ............................................................................6 1.3 Future/Present value of money ....................................................................7 1.4 Discounted cash flow (DCF)..........................................................................8 1.4.1 History of discounted cash flow (DCF) .................................................9 1.5 Risk in context ................................................................................................ 10 1.6 Valuation of a business................................................................................ 12 1.7 Problem discussion........................................................................................ 13 1.7.1 Why do these valuations differ? ......................................................... 13 1.7.2 How does one know which of these values is the most accurate? ............................................................................................................................. 13 1.8 Purpose............................................................................................................ 15 1.9 Previous research and potential contribution........................................ 16 1.10 Industry and economic background..................................................... 17 Chapter 2 Literature review.................................................................................. 22 2.1 The investment process ............................................................................... 22 2.2 Risk attitude and perspective .................................................................... 23 2.2.1 Fundamentals of risk management................................................... 23 2.2.2 An approach to risk management.................................................... 25 2.3 Valuation ........................................................................................................ 27 2.3.1 Why is business valuation important?................................................ 27 2.4 Valuation models.......................................................................................... 27 2.5 Asset based valuation ................................................................................. 28 2.5.1 Value of assets........................................................................................ 29 2.5.2 Liabilities ................................................................................................... 30 2.6 Absolute valuation or discounted cash flow (DCF) models................ 30 2.6.1 Incorporate financial and non-financial performance data...... 33 2.6.2 Free cash flow (FCF) discount models .............................................. 35 2.6.3 Calculating the terminal value........................................................... 42 2.6.4 Calculating the discount rate............................................................. 43 2.6.5 Country risk and cost of capital.......................................................... 48 2.6.6 Calculating total enterprise value (EV)............................................. 54 2.6.7 Calculating the value of equity (Ve) ................................................. 55 2.6.8 How do the analysts value a business that is losing money?....... 55 2.6.9 Pros and cons of discounted cash flow DCF................................... 57 2.6.10 Summary................................................................................................ 58 2.7 Discounted dividend model....................................................................... 58 2.8 Relative valuation ......................................................................................... 60 2.8.1 First principles: ......................................................................................... 60 2.8.2 What is relative valuation?................................................................... 62 2.8.3 Reasons for popularity .......................................................................... 62 2.8.4 Potential pitfalls ...................................................................................... 63 2.9 Reconciling relative and discounted cash flow valuations ................ 63 Chapter 3 Methodology ....................................................................................... 65 3.0 Method approaches.................................................................................... 65 3.1 Inductive or deductive approach............................................................ 65 3.2 Quantitative and qualitative approach.................................................. 65 3.3 Research approach..................................................................................... 66 3.4 Research design............................................................................................ 66 3.5 Data collection methods............................................................................ 67 3.5.1 Sample ..................................................................................................... 67 3.6 Modes of data collection ........................................................................... 67 3.6.1 Advantages of questionnaire ............................................................. 68 3.6.2 Disadvantages of questionnaire ........................................................ 68 3.7 Deductive approach................................................................................... 68 3.8 After the interviews, the following steps were taken: ........................... 71 3.9 Reliability and validity of the data............................................................ 71 3.10 Statement of hypothesis............................................................................ 72 3.11 Statistical techniques used in the analysis ............................................ 72 3.12 Summary....................................................................................................... 72 Chapter 4 Results and discussion ........................................................................ 73 4.0 Introduction.................................................................................................... 73 4.1 Descriptions of participants ........................................................................ 73 4.2 Participants’ views ........................................................................................ 73 4.2.1 Valuation techniques............................................................................ 74 4.2.2 SWOT analysis.......................................................................................... 75 4.2.3 Financial forecasts................................................................................. 76 4.2.4 Terminal value......................................................................................... 78 4.2.5 Cost of debt ............................................................................................ 80 4.2.6 Risk free rate............................................................................................ 81 4.2.7 Risk premium ........................................................................................... 81 4.2.8 Beta estimate.......................................................................................... 82 4.2.9 Cost of equity.......................................................................................... 83 4.2.10 Discount rate......................................................................................... 84 4.2.11 Responses to open questions............................................................ 84 4.3 Inferential statistics........................................................................................ 95 4.3.1 Tables 1 (r) to v (r) .................................................................................. 97 4.4 Analysis of hypothesis................................................................................. 101 4.5 Discussions .................................................................................................... 102 4.5.1 Risk and uncertainty............................................................................ 107 4.5.2 Valuation of businesses under distress............................................. 112 4.5.3 Adapting discounted cash flow valuation to distress situations 114 4.5.4 Valuing high growth businesses........................................................ 119 Chapter 5 Recommendations and implications ........................................... 125 5.1 Introduction.................................................................................................. 125 5.2 Summary ......................................................................................................