I got this email from Mike Adhikari informing me about the Advanced Growth Model that he introduced as a better model compared to over-simplified capital structure assumption in the Gordon Growth Model.

Hello Sukarnen:

Capitalization 2.0 will be released at the NACVA Conference on June 5th, 2019.

The current single-period capitalization method, and the method used to calculate the terminal value in the multi-period DCF are used when the business is growing at constant rate. These methods implicitly assume that, after the willing buyer buys the business, the capital structure of the business will remain constant, and that the debt principal will not be amortized (i.e. debt will never be repaid.)

Capitalization 2.0 eliminates these assumptions. It considers that even when the business is growing at a constant rate, the debt principal may have to be paid down, and hence the capital structure will change.

Current methods use Gordon Growth Model (GGM) formula, whereas Capitalization 2.0 uses the newly developed Advanced Growth Model (AGM) formula. Typically, GGM formula overvalues a business by 10-50%

Unlike the GGM formula, the AGM formula is complex; hence, a spreadsheet of AGM formula can be downloaded (free for a limited time) from the website www.AltBV.com.

Upon visiting his website, I got two papers that I could downloaded, as enclosed, and the summary of the differences in the results between Gordon Growth Model vs Advanced Growth Model, as follows:

I think this Advanced Growth Model concept is interesting as the capital structure assumption is on of the critical assumption in all valuation models. The issue, can we assume away, the capital structure to be constant, and no principal debt repayment in the long-term?


June 2019

2 Articles by Mike Adhikari:

Article: Advanced Growth Model Reduces The Risk of Overvaluing From ‘Constant WACC’ Assumptions

Advanced Growth Model 0609 BVUpdate

Article : WACC as used in capitalization formula causes overvaluation


Raul Ibragimov:

Hello Sukarnen

Regarding the statement “…  constant WACC is making more sense than variable WACC …”, I disagree, moreover, I would say the constant WACC is an artificial construct. One may reasonably assume that the risk of firm’s assets (i.e. Ku) stays unchanged, but Ke and WACC will vary due to cash flow fluctuations and changes in the debt level.
The “AGM Model to challenge constant WACC” is dubious. In the background section the author mentions a setting where the debt is to be paid down and at the same time he assumes constant return expectations by the equity holder. These are confusion. When debt is paid down or held for n periods while the cash flows grow at a rate g, the leverage and hence the cost of equity Ke (expected return) would definitely change. A model based on incompatible assumptions makes no sense, so, going into subsequent algebra would be a waste of time, unless there’s an intention to write a reply.
There are two surprising statements on the second page. Saying “WACC ignores debt principal repayment” is a manifestation of not knowing the true mechanics of FCF-WACC valuation. See the writings of Ignacio and Joe to clear that out. Another one is arguing that debt has value other than its tax shields. What Mike Adhikary means, I wonder? He doesn’t consider any debt subsidy, neither does he differentiate between the contractual interest rate on debt and the cost of the debt capital.
Ignacio Velez-Pareja:
Hello, you all!
The debate is very “simple” to define: Ke and WACC depend on cashflows!!!!
Why? Let’s see what happens with Ke, for instance.
Ke = Ku + (Ku-Kd)D/E D and E are at t-1 and Ke and Ku and Kd at t.
E is the PV of CFE from t to N at Ke. This generates circularity but that is a different problem.
Constant Ke and WACC could exist forcing D to be a constant % of V at any time. Karnen has worked this case. Karnen, could you explain the cases you have been working on?
Yes, constant WACC and/or Ke are a construct and it doesn’t make more sense. What is usual in a firm is to contract loans as needed and the repayment of those loans define the level of debt and leverage. In practice, it makes no sense to ask the bank to repay or acquire new debt almost at random. Banks need some certainty in their cashflows. If debt is public debt, the situation is worse. To put bonds in the market is not an easy task that can be done, say, on a monthly base, not even on a yearly base!
Agree with Rauf. People try to adjust theory to their particular interests.
Joseph Tham:
We have always assumed that consistency is a strong and persuasive argument.

Forget taxes. In a world with perfect capital markets, if financing is simply equivalent to slicing a pizza, then it is possible to slice the pizza with no loss in value.
This means that the sum of the divided pizza must equal the whole pizza. No more, no less. We can illustrate this with the simplest two period example. Forget perpetuities. QED
Rauf Ibragimov:
As far as I see, the point Sukarnen introduced to discuss was not the constant vs variable WACC debate (which would be strange iin this consistency lovers club), but Adhikary’s new formula to substitute Gordon’s growing perpetuity. My comments go to that.
I dare say, that the statement “Ke and WACC depend on cashflows!!!!” is impresise. Take the setting of no debt, then Ke=WACC=Ku irrespective of CFs. Actually, Ke and WACC depend on Ku and debt level, the latter causes varying leverage and TSs contribution => varying Ke and WACC
Joseph Tham:
Growing cash flows in perpetuity?
I insist that we need to think about finite cash flows. Perpetuity is inflexible.

Even a 1000 years is not a reasonable approximation to perpetuity. I am stuck at this nonsensical assumption. This is my fundamental psychological barrier. Has always been.
Ignacio Velez-Pareja:
OK, Rauf, thanks for your comments and precision, however, under no debt and constant inflation, yes, WACC is constant and does not depend on CFs. Even with variable inflation, WACC doesn’t depend on CFs…
Joseph Tham:
If inflation is variable, then the nominal WACC may vary but the real WACC will be constant. Agree?

However, suppose the risk of the cash flow changes for some exogenous reason from years 5 to 10. Then the cost of capital real from years 5 to 10 may be different from the first five years. Agree in principle?
Ignacio Velez-Pareja:
If inflation is variable, then the nominal WACC may vary but the real WACC will be constant. Agree?
IVP: Yes, agree in general terms. The nominal cost of debt and equity   would be constant
However, suppose the risk of the cash flow changes for some exogenous reason from years 5 to 10. Then the cost of capital real from years 5 to 10 may be different from the first five years. Agree in principle?
IVP : Yes, in general, yes…
Then what?

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