THE DISCOUNTED CASH FLOW MODEL

As we described in the previous section, the value of an asset or investment is the present value of the
net cash payoffs that the asset generates. The discounted cash flow valuation model clearly reflects this
basic principle of finance. The model defines the value of a firm’s business assets as the present value of
cash flows generated by these assets (OCF) minus the investments made in new assets (Investment), or,
alternatively stated, as the sum of the free cash flows to debt and equity holders discounted at the
weighted average cost of debt and equity (WACC). Asset value0 ¼ PV of free cash flows to debt and
equity claim holders ¼ OCF1 Investment1 ð Þ 1 þ WACC þ OCF2 Investment2 ð Þ 1 þ WACC 2 þ ... Note
that in this equation OCF excludes interest payments (unlike the operating cash flows reported in IFRS-
based cash flow statements), as these are distributions to debt holders. The cash flows that are available
to equity holders are the cash flows generated by the firm’s business assets minus investment outlays,
adjusted for cash flows from and to debt holders, such as interest payments, debt repayments, and
debts issues. As discussed in Chapter 5, operating cash flows to equity holders are simply net profit plus
depreciation and amortization less changes in working capital. Investment outlays are expenditures for
noncurrent operating and investment assets less asset sales. Finally, net cash flows from debt owners
are issues of new debt less retirements. By rearranging these terms, the free cash flows to equity can be
written as follows: Free cash flows to equity ¼ Net profit DBVA þ DBVD where DBVA is the change in
book value of business assets (changes in working capital plus investment expenditures less depreciation
and amortization expense), and DBVD is the change in book value of (interest-bearing) debt. Using the
discounted cash flow model, equity value is thus estimated as follows: Equity value0 ¼ PV of free cash
flow to equity holders ¼ Net profit1 DBVA1 þ DBVD1 ð Þ 1 þ re þ Net profit2 DBVA2 þ DBVD2 ð Þ 1 þ re
2 þ ..