hard · Principles of Finance valuation
An analyst values a firm with a two-stage FCFF model. He correctly computes enterprise value, then subtracts the market value of debt to get equity value. A colleague points out that the firm holds a 30% stake in an unconsolidated affiliate, accounted for under the equity method, whose earnings flow through the income statement below operating income. The analyst's FCFF was built up from EBIT.
Which single adjustment most accurately corrects the equity value?
- No adjustment is needed, because equity-method investment income already flows through net income and is therefore captured in the FCFF the analyst projected.
- Add the fair value of the 30% affiliate stake to equity value, because that income was excluded from an EBIT-based FCFF and the stake is a non-operating asset.
- Subtract the affiliate's proportional debt from equity value, since equity-method accounting hides the firm's share of the affiliate's leverage.
- Add the affiliate's reported equity-method earnings, capitalized at the firm's WACC, to enterprise value before subtracting debt.
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