The value of an asset today is the present value of the future cash flows that the asset is expected to provide its owners during its economic life. Thus, a significant aspect of valuation involves modeling the future cash flows associated with an investment and then deciding how to value those cash flows. Alternative valuation methods have also emerged because not all investments have sufficently predictible cash flows to permit effective financial modeling. In this essay firstly I will discribe the valuation issues, secondly I will describe the market pricing approaches and finally the discounted cash flow model will be analysed in detail.

Valuation issues includes the question of what "fair market value" is. Fair market value is the highest price obtainable in an open and unrestricted market between knowlegable, informed and prudent parties acting at arm's lenght, with neither party being under any compulsion to transact. Determining fair market value depends on the perspective of the acquirer. Some acquirers are more likely to be able to realize synergies than others and those with the greatest ability to generate synergies are the ones who can justify higher prices. There are three types of acquirers that their perspective has impact on the value. The first one is passive intevstors who use estimated cash flows currently present. Second one is strategic investors who use estimated synergies and changes that are forecast to arise through integration of operations with their own. Finally we have managers who value the firm based on their own job potential and ability to motivate staff and reorganize the firm's operations. Market pricing will reflect these different buyers and their importance at different stages of the business cycle.

There are two different market pricing approaches, namely Reactive Pricing Approachs and Proactive Models. The first one is the Reactive Pricing Approach where models reacting to general rules of thumb and the relative pricing compared to other securities. It includes Liquidation and Breakup Values. Break-up value refers to the amount that could be realized if a company were split into saleable units that could be disposed on in a negotiated transaction. Liquidation value refers to the amount that could be realized if a company were liquidated in a distress sale. A company's liquidation value is usually lower than its book and break-up values because assets that must be disposed of quickly are usually sold at a discount. There are three steps to find liquidation value: firstly we should estimate the liquidation value of current assets, secondly we should estimate the present value of tangible assets and finally we should substract the value of the firm's liability from estimated liquidation value of all the firm's assets.

Proactive model is a valuation method to determine what a target firm's value should be based on future values of cash earnings. Under this scope, we have Discounted cash flow (DCF) models. The key to using the DCF approach to price a target firm is to obtain good forecasts of free cash flow. Free cash flows to equity holders represents cash flows left over after all obligations, including interest payments have been paid. DCF valuation takes the following steps: Firstly, we should forecast free cash flows, secondly we should obtain a relevant discount rate and finally we chould discount the forecast cash flows and sum to estimate the value of the target.

Free cash flow to equity = net income +/- non-cash items +/- changes in net working capital - capital expenditures.

We have three different DCF models. Firstly we have the general DCF model which is the generalized version of the DCF model showing how forecast free cash flows are discounted to the present and then summed.

The formula is as follows: V0 = CF1/ (1 + k)1 + CF2/ (1 + k)2 + .... CFa/ (1 + K)a

Secondly we have the constant Growth DCF model which is the DCF model for a target firm where the free cash flows are expected to grow at a constant rate for the foreseable future

The formula is as follows: V0 = CF1 / k-g

Many taget firms are high growth firms and so a multi-stage model may be more appropriate. The multi-stage DCF model can be amended to include numerous stages of growth in the forecast period.

The formula is as follows: V0 = CFt / (1 + K)t + Vt / (1 + K)t

K: discount rate CF: free cash flows T: time period VT: Terminal value

In conclusion, once the value to the acquirer has been determined, the acquisition will only make sense if the target firm can be acquired at a price that is less. As the acquirer enters the buying process, the outcome is not certain because competing bidders may appear, arbitrageurs may buy up outstanding stock and force price concessions and lenghten the acquisition process or finally in the end, the forecast synergies might not be realized.

**21.02.2018**

**Atty Gonenc Yay, LL.M**