Introduction to Discounted Cash Flow Valuation

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# Introduction to Discounted Cash Flow Valuation - PowerPoint PPT Presentation

Introduction to Discounted Cash Flow Valuation. Nicholas Ramm Finance Sector, Madison Investment Fund October 29, 2007. What is DCF analysis?. Method of valuing a financial asset Focus on firms Uses cash flows Find present value of these cash flows. Present Value.

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### Introduction to Discounted Cash Flow Valuation

Nicholas Ramm

October 29, 2007

What is DCF analysis?
• Method of valuing a financial asset
• Focus on firms
• Uses cash flows
• Find present value of these cash flows
Present Value
• Value of future money today

FV

PV=

(1+R)T

The Concept-Part 1

Cash Flow

Firm Value =

\$1 + \$2 + \$3+ \$4 + \$5 + …

(1+R)1 (1+R)2 (1+R)3 (1+R)4 (1+R)5

Discount Rate

Need CFs forever

Free Cash Flow
• Measure of money available to investors
• FCF = (Net Inc.) +

(Depreciation/Amortization) -

(CapEx) -

(Increase in Working Capital) +

(Misc. firm-specific items)

• All items available in financial statements
Forecasting
• Inherently subjective
• Choose a forecast period and a method to generate FCFs
• Percentage of sales, Construct new financial statements
The Concept-Part 2

Firm Value =

FCF1 + FCF2 + FCF3 + FCF4 + FCF5 + …

(1+R)1 (1+R)2 (1+R)3 (1+R)4 (1+R)5

Discount Rate

Need CFs forever

Terminal Year
• Can’t forecast forever
• Assume company stabilizes
• Grows at G forever
Terminal Year

FCFTY * (1 + G)

TYV =

R - G

The Concept-Part 3

Firm Value =

FCF1 + FCF2 + FCF3 + FCF4 + FCF5 +…+ TYV

(1+R)1 (1+R)2 (1+R)3 (1+R)4 (1+R)5 (1+R)TY

Discount Rate

Discount Rate
• Cash Flows and Terminal Year Value must be discounted
• Need rate that takes into account relative risks of business
Weighted Average Cost of Capital

E

D

R* =

RE *

RD *

* (1-t)

+

D+E

D+E

Weighted Average Debt interest rate

Obtain Using CAPM

Capital Asset Pricing Model

RE =

RF + β * (Rm – Rf)

Putting it All Together

Firm Value =

FCF1 + FCF2 + FCF3 + FCF4 + FCF5 + …+TYV

(1+R*)1 (1+R*)2 (1+R*)3 (1+R*)4 (1+R*)5 (1+R*)TY

Limitations
• Forecasting error:
• Future cash flows
• Future capital structure
• Terminal growth rate
• Assume unchanging firm
• Capital Structure
• Terminal growth rate