DCF (final)

DCF Model:

DCF Model The DCF estimates the intrinsic value of an asset, based on the fundamentals. Intrinsic value = PV of the benefits associated with it Advantages The value is estimated as a sum of all components that make up the enterprise value, instead of just the equity. It can be applied to the company as a whole and also to SBU. It is consistent with the capital budgeting process

Basis of DCF valuation:

Basis of DCF valuation DCF is based on the concept of time value of money. The value of an asset is computed as the PV of all expected future cash flows that the asset generates. t=n Value = Sum CF t t=1 (1+K)t N= life of the asset CF t= cash flow period t, and K = discount rate Discount rate is the function of the risk of the estimated cash flows. Riskier assets have higher discount rates and safer assets have lower discount rates. t

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DISCOUNTED CASH FLOW MODELS THERE ARE MANY BUT THE EXTENT OF VARIATION IS LTD THERE ARE BASICALLY THREE MODELS TO DISCOUNT CASH FLOW VALUATION CASH FLOW TO EQUITY MODEL CASH FLOW TO FIRM MODEL ADJUSTED PRESENT VALUE MODEL CASH FLOW TO EQUITY USED TO MEASURE EQUITY STAKE IN THE COM VALUE OF EQUITY IS OBT BY DISCOUNTING THE CASH FLOW TO EQUITY CASH FLOWS ARE AFTER CONSIDERING ALL EXPENSES AND REINVESTED NEEDS, TAX OBLIGATION AND NET DEBT PAYMENTS. CASH FLOWS ARE DISCOUNTED AT THE RATE OF RETURN REQUIRED BY EQUITY INVESTORS IN THE FIRM

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VALUE OF EQUITY= E T=n=1 CF TO EQUITY ________________ (1+Ke) t CF TO EQUITY = EXPECTED CASH FLOW Ke= COST OF EQUITY THE DIVIDEND DISCOUNT MODEL IS A SPECIAL CASE OF EQUITY VALUATION, WHERE THE VALUE OF EQUITY IS THE PRESENT VALUE OF EXPECTED FUTURE DIVIDENDS. 2. CASH FLOW TO FIRM APPROACH: COMPUTE THE VALUE OF THE ENTIRE FIRM. INCLUDES CASH FLOW AVAILABLE TO ALL SUPPLIERS OF CAPITAL TO FIRM LIKE THE

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EQUITY SHARE HOLDERS , BOND HOLDERS AND PREFERRED STOCK HOLDERS VALUE OF FIRM IS OBTAINED BY DISCOUNTING ALL EXPECTED FUTURE CASH FLOWS OF THE FIRM AFTER MEETING OPERATING EXPENSES , REINVESTMENT NEEDS AND TAXES BUT BEFORE ANY PAYMENT TO EITHER DEBT OR EQUITY HOLDERS CASH FLOWS ARE DISCOUNTED AT THE WEIGHTED AVERAGE COST OF CAPITAL WHICH IS THE COST OF DIFFERENT COMPONENTS OF FINANCING USED BY THE FIRM. THE ADJUSTED PV APPROACH IS USED TO VALUE EACH CLAIM SEPERATELY IN THIS APPROACH FIRM IS VALUED IN PIECES

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BEGINNING WITH OPERATIONS, ADDING THE EFFECTS ON VALUE OF DEBT AND OTHER EQUITY CLAIM HOLDERS VALUE OF EQUITY COMPUTED FIRST THEN VALUE ADDED (OR TAKEN AWAY) BY DEBT, CONSIDERING PV OF TAX BENEFITS DUE TO DEBT LASTLY, EXPECTED BANKRUPTCY COST IS CONSIDERED VALUE OF FIRM = VALUE OF ALL EQUITY FINANCED FIRM + PV OF TAX BENEFIT - EXPECTED BANKRUPTCY COST ALL MODELS ON DISCOUNTED CASH FLOW ARE BASED ON SAME PRINCIPLE BUT THE RELEVANT CASH FLOW AND DISCOUNT RATES IN EACH DIFFER.

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STEPS IN DISCOUNTED CASH FLOW VALUATION 4 STEPS IN ESTIMATING VALUE UNDER DCF MODEL: ESTIMATING FREE CASH FLOW FOR FORECAST PERIOD ESTIMATING GROWTH IN EARNINGS COMPUTING COST OF CAPITAL COMPUTING CONTINUING VALUE DETERMINING VALUE

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ESTIMATING FREE CASH FLOW FOR FORECAST PERIOD – VALUE OF ASSET DIRECTLY PROPORTIONAL TO CAPACITY TO GENERATE CASH FLOW. ESTIMATING CASH FLOW BASED ON 3 PRINCIPLES:

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CASH FLOW SHOULD BE AFTER TAXES – MEANING ALL CASH AND NON CASH ITEMS LIKE DEPRECIATION, SUBJECT TO TAX IS TO BE CONSIDERED WHILE ESTIMATING CASH FLOW CASH FLOW SHOULD BE INCREMENTAL - MEANING, CASH INFLOWS AND OUTFLOWS, DIRECTLY OR INDIRECTLY ATTRIBUTED TO PROJECT SHOULD BE CONSIDERED. CASH FLOW AND DISCOUNT RATES SHOULD BE CONSISTENT – MEANING, IF CASH FLOW IS TO EQUITY INVESTORS, DISCOUNT RATE = COST OF EQUITY; AND IF TO ENTIRE FIRM, DISCOUNT RATE IS WEIGHTED AVERAGE COST OF CAPITAL.

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CASH FLOWS SHOULD BE AFTER TAX PROJECTS EXPECTED TO GENERATE INCOME ALWAYS SUBJECTED TO TAX ANALYSTS FACE THE CHOICE OF TWO DIFFERENT TAX RATES – EFFECTIVE TAX RATE AND MARGINAL TAX RATES – WHILE ANALYSING IMPACT OF TAXES ON CASH FLOWS. EFFECTIVE TAX RATE = WIDELY REPORTED TAX RATE IN THE FINANCIAL STATEMENTS. TOTAL TAX PAID AS A PROPORTION OF THE TOTAL INCOME GENERATED BY A BUSINESS.

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MARGINAL TAX RATE = TAX ON LAST RUPEE GENERATED IN BUSINESS. MARGINAL TAX RATE DEPENDS ON GOVT REGULATIONS & GIVES WHAT FIRMS HAVE TO PAY AS TAXES ON THEIR MARGINAL INCOME.

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REASON FOR DIFFERENCE IN ETR AND MTR always A DIFFERENCE OF ACCOUNTING STANDARDS FOLLOWED FOR TAX PURPOSE AND REPORTING PURPOSE SOME COM USE SLM DEP FOR REPORTING AND WDV FOR TAX PURPOSE RESULTING INTO HIGHER INCOME FOR REPORTING PURPOSE 2 TAX CREDT USED BY THE FIRM TO REDUCE TAXES , IN TURN REDUCE THE EFFECTIVE TAX RATE BELOW MARGINAL TAX RATE 3 WHEN FIRMS DEFFER TAX PAYMENTS TO FUTURE PERIODS, THE EFFECTIVE TAX RATE WILL BE DIFFERENT FROM THE MAREGINAL TAX RATE

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THE INCOME GENERATED BY THE FIRMS EXISTING ASSETS AND PROJECTS IS MARGINAL , HENCE MTR IS MORE APPRORIATE TO ELIMINATE TAX LIABILITY IF SAME TAX RATE IS TO BE APPLIED TO EARNINGS EVERY PERIOD , MTR IS MORE APPROPRIATE TERMINAL VALUE IS always TO BE CALCULATED AT MTR. NON CASH ITEM LIKE DEP REDUCE CASH FLOW BUT DO NOT CAUSE A REAL CASH OUTFLOW. HENCE DEP IS ALWAYS ADDED BACKTO NET INCOME TO ARRIVE AT CASH FLOW OF PROJECT TAX BENEFIT FROM DEP= DEP*MTR

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IILUS-1: APEX LTD IS EVALUATING AN INVESTMENT PROPOSAL TO MANUFACTURE TRUCKS FOR HORIZON LTD., THE PROJECT WILL REQUIRE AN INITIAL INVESTMENT OF 10 LAKHS IN PLANT AND MACHINERY. THE INITIAL INVESTMENT WILL BE DEPRECIATED ON SLM DOWN TO A SALVAGE VALUE OF 2 LAKHS AT THE END OF 8 YEAR. THE PROJECT WILL GENERATE REVENUE OF RS3 LAKHS AND WILL INCUR OPERATING EXPENSES OF RS 1 LAKH IN THE FIRST YEAR. THESE REVENUS AND EXPENSES ARE EXPECTED TO GROW AT 5% A YEAR OVET THE REMAINING 7 YEARS OF THE RPOJECT THE MTR OF THE COM IS 36%. ESTIMATE THE FLOWS TO the FIRM. (ASSUME THE COST OF CAPITAL AT 10%). Ans: DCF example.xls

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CASH FLOWS SHOULD BE INCREAMENTAL: IMP PRINCIPLE IN ESTIMATING CASH FLOWS. ONLY THOSE CASH FLOWS THAT AFFECT THE INFLOW AND OUFLOW OF CASH SHOULD BE TAKEN FOR A PROJECT FOR ITS VALUATION. MANY FACTORS ARISE IN THE CONTEXT OF CAPITAL BUDEGTING SUCH AS: SUNK COSTS: EXPENSES INCURRED BEFORE THE PROJECT ANALYSIS IS DONE & CAN NOT BE RECOVERED IF THE PROJECT IS NOT TAKEN UP. SINCE SUCH EXP. CAN’T BE RECOVERED IF THE PROJECT IS REJECTED, HENCE SUNK COST ARE TO IGNORED.

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WORKG CAPITAL” DIFF BET CURRENT ASSETS AND CURR LIAB AFFECTS CASH FLOW BUT NOT ACCOUNTING INCOME WHILE ESTIMATING THE EFFECT OF CHANGES IN WRKG CAP ON CASH FLOWS THE CURRENT PORTION OF LONG TERM DEBTS AND CASH SHOULD BE ELIMINATED WHILE ESTIMATING THE WORKING CAPITAL.

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CURRENT PORTION OF LONG TERM DEBTS IS ELIMINATED FOR TWO REASONS 1. TO AVOID DOUBLE COUNTING SINCE IT IS ALREADY CONSIDERED AS A PART OF THE OVERALL FINANCING OF THE PROJECT. OBJECTIVE IS TO ESTIMATE FUTUE WRKG CAP NEEDS, CURRENT PORTION OF LONG TERM DEBTS IS GENERALY HIGHLY VARIABLE AND UNPREDICTABLE. CASH IS NOT TO BE CONSIDERED WHILE ESTIMATING EFFECT ON WC. WHILE ESTIMATING CHANGES IN WC ONLY NON CASH ITEMS ARE TO BE CONSIDERED NON CASH WC= CA-CL( CL IS NOT INCLUDING CURRENT PORTION OF LONG TERM DEBTS) =( INV+ ACCREC)-(ACCPAY+ TAXES PAYABLE)

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INCREASE IN WKG CAP IS CASH OUTFLOW AND DECREASE IN WC IS CASH INFLOW. WC ESTIMATES EXPECTED GROWTH IN REVENUES AND EXPENSES. FAILURE TO CONSIDER WC REQ IN INVT ANALYSIS HAS TWO SERIOUS CONSEQUENCES. WRKG CAP TENDS TO INCREASE IN THE INITIAL YEARS CAUSING CASH OUTFLOW HENCE IGNORING WRKG CAP IN INVT ANALYSISI LEADS TO OVERESTIMATION OF AFTER TAX CASH FLOWS NPV OF THE PROJECT WILL ALSO BE OVERSTATED

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HENCE AFTER TAX CSH FLOWS TO THE FIRM ARE = EBIT(1-t)+ DEP- CAP EXP-CHANGES IN WC OR EBIT ****** - TAXES ****** -(CAP EXP- DEP) ****** - CHANGE IN WC ****** OPPORTUNITY COSTS: EXPECTED RETURN THAT CANBE EARNED IN THE NEXT BEST INVT TAKES THE FORM OF RENTALS LOSTOR THE FORGONE SALES PRICE OR COST OF REPLACING THE ASSETS. HENVE PV OF OC IS ADDED FOR NPV

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ALLOCATED COSTS: ARE THOSE COSTS THAT CANNOT BE ALLOCATED DIRECTLY TO THE BUSINESS SUCH COSTS CANNOT BE DIRECTLY TRACED TO A UNIT OR PRODUCT AND ARE HENCE TRACED TO ALL DIVISIONS BASED ON REVENUE OR PROFITS THIS IS INCLUDED IN INVESTMENT ANALYSIS 2. CASH FLOW SHOULD BE CONSISTENT: THE CASH FLOW AND DISCOUNT RATE SHOULD BE ESTIMATED CONSISITENTLY IN TERMS OF INFLATION THE first IS TO ESTIMATE CASH FLOW ASSOCIATED WITH DEBT FINANCING (INTEREST AND PRINCIPAL) & THEN TO CALCULATE

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LEFT OVER FOR EQUITY SH INVESTORS CASH FLOW TO EQUITY TO BE DISCOUNTED AT COST OF EQUITY. THE PV OF EQUITY IS COMPARED TO EQUITY INVT IN THE PROJECT TO CALCULATE NPV OR IRR SECOND METHOD IS TO CALCULAET CUMULATIVE CASH FLOW TO BOTH EQUITY INVESTORS AND LENDERS AND THEN DISCOUNT IT AT COC WHICH IS OBTAINED AT WEIGHTED AVERAGE OF RATE OF RETURN OF EQUITY SH HOLDERS AND AFTER TAX COST OF BORROWING. INFLATION CAN BE DEALT WITH IN TWO WAYS

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THE first IS TO INCORPORATE THE EXPECTED INFLATION IN THE ESTIMATES OF FUTURE CASH FLOWS. RESULTING IN NOMINAL CASH FLOW AND THEN DISCOUNT THESE AT NOMINAL DR WHICH ALSO INCORORATES INFLATION THE NEXT IS TO ESTIMATE CASH FLOWS IN REAL TERMS AND DISCOUNT THE REAL CASH FLOWS AT REAL DISCOUNT RATE. = NOMINAL CASH FLOWS/(1+ EXPECTED INF RATE)t NOMINAL DISCOUNT RATE= (1+ RDR)(1+ EI)-1 EI= EXPECTED INFLATION

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END

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FCFE= FCFF+ BORR-INT(1-taxes)- PRINC REPAID IILL-2 ESTIMATE CASH FLOWS TO EQUITY AND CASH FLOWS FROM DEBTS INFORMATION: EBIT-RS 500LAKHS CAPITAL EXP – RS 300 LAKH DEPRECIATION- RS 200 LAKHS REVENUE – RS 7000 LAKHS WC AS A % OF REVENUE- 25% TAX RATE- 36%

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THE REVENUES AND EARNINGS ARE EXPECTED TO GROW AT A STABLE GROWTH OF 5% FOR 5 YEARS CAPITAL EXP IS OFFSET BY DEPRECIATION. ESTAMTE FREE CASH FLOWS TO FIRMS AND FREE CASH FLOW TO EQ SH. HOLDERS. Ans: FCF (after tax cash flow)= EBIT(1-t)+Dep-Capital exp. – change in non cash WC

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ILLUS-3 ABX LTD REQUIRES AN INITIAL INVT OF 12 LAKHS. FOR ITS NEW STORES FROM WHICH 4 LAKHS WOULD COME FROM BORROWINGSAT INT OF 8%. INT IS PAID FOR 5 YEARS AND ENTIRE PRINCIPAL WITH INT IS REPAID AT END OF SIXTH YEAR INT EXPS ARE TAX DEDUCTIBLE AT RATE OF 36% BUT THE PRINCIPAL PAYMENTS ARE NOT. THE CSH FLOWS TO THE FIRM ARE EXPECTED TO BE 80000 INITIALLY. THESE CASH FLOWS ARE EXPECTED TO GROW AT A RATE OF 30% FOR THE FIRST 4 YEARS AT 75% FROM 5TH YEAR ONWARDSESTIMATE FREE CASH FLOW TO EQYITY.