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Discounted Cash Flow – Sequential Valuation

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- In this class, we will value companies using Discounted Cash Flows.
- We will use the Sequential method to determine the stock price.
- To do this valuation, we will break the firm’s life into two stages.
- Non-constant growth period
- Constant Growth period.

- To value the cash flows during the non-constant growth period, we need
- Estimate Cash flow for all years
- Discount cash flow
- Note: growth annuity calculation may be helpful but can only use if r > g!

- During the non-constant growth period, the firm may go through many different growth cycles.
- Only when the we can assume that growth is stable and will remain unchanged, does the non-constant growth period end.

- Once the non-constant growth ends, the constant growth period begins.
- To value the firm during the constant growth period, we must calculate a Terminal Value
- Two ways typically calculated
- If can estimate constant growth rate, use perpetuity equation.
- Timing is essential here.
- You use the cash flow after one year of the constant growth rate.
- This gives the value at the point when growth became constant, so the value must be discounted to t=0.

- If you are unable to estimate constant growth, you can use an exit multiple.

- If can estimate constant growth rate, use perpetuity equation.

- Two ways typically calculated

- Different cashflows have different levels.
- A firm could have different divisions with different risk levels.
- Certain cashflows could be certain and others are uncertain or risk.
- Example: If you know you will have $20,000 of depreciation for the next 10 years and the tax rate is 30%, then the depreciation tax shield is a riskless cash flow

- Use risk-adjusted discount rates to value risky cash flows
- Use the risk-free discount rate to value riskless cashflow

- Be consistent in your treatment of inflation
- Use nominal cash flows and a discount rate that accounts for inflation.
- Use real cash flows and a discount rate that ignores the effect of inflation.

- Consider the timing of the cash flows
- End of the year versus Beginning of the year.
- Best approximation: Mid-year discounting.

- From the Benninga and Sarig text book, Chapter 3, Cash Flow this year is
- Profit After Tax (net income)-30,203
- Depreciation - 20,000
- Interest Expense (net of tax)22,496
- Free Cash Flow72,699

- Change Assumptions from the book
- FCF (excluding depreciation tax shield) grows at 10% for the next 10 years (the book assumed it was constant). This is above the industry average.
- After 10 years, growth stabilizes. However, you are uncertain what the stable growth rate will be.
- You know that similar real estate assets have a price to earnings ratio of 8 and you expect the same for your hotel in 10 years.

- Different Cash flows have different risks. So, when you value the cash flow consider different risk levels.
- Free Cash Flow72,699
- Depreciation Tax Shield
(20,000 x .30304)

- Operating Cash Flow
(residual)

- Depreciation Tax Shield

- Is the depreciation tax shield a real or nominal cashflow?
- It will not change so it is nominal , so it must be discounted using an rate including inflation (nominal rate)

- Is it a risky cash flow?
- No, so we use the nominal, riskfree rate.

- Our estimates do not account for changes that occur due to inflation, so it is a real cash flow and must be discounted using a real rate.

- Yes, so we use the real, risky rate.

- The terminal value
- Is the terminal cashflow nominal or real?
- If it is based on nominal earnings, then it is nominal

- Is it risky? – yes,
- so nominal risky rate is used.

- Is the terminal cashflow nominal or real?
- Terminal Value using exit multiple

- Real RADR (risky) = 20%(given)
- Real Riskfree = 7%(given)
- Inflation = 3%(given)
- Nominal RADR =
- Nominal Riskfree =

- PVA (real operating CF, g=10%, 20%, 10 yrs at mid-year)
- PVA (nominal tax shield CF, 10.21%, 10 yrs at mid-year)
- PV (Terminal Value, 10 yrs, 23.6%)
- Firm Value
- Equity Value
- Debt value given in text.