MAC 4

DISCOUNTED
CASH FLOW
METHOD
 Discounted Cash Flow Method

• In Financial Management, it has been discussed that

a way to determine the value of an investment
opportunity is by determining the actual cash
generated by a particular asset.

• In Conceptual Framework and Accounting Standards,

it was discussed that the cash flows are presented
and analyzed based on their sources and activities
which are categorized as operating, investing and
financing.
• The Net Cash Flows refer to the amount of cash available
for distribution to both debt and equity claims of the
business or asset. This is calculated from the net cash
generated from operations and for investment over time.

• For GCBO, the net cash flows generated will be based on

the cash flows from operating and investing activities, since
this represents already the amount earned or will be
earned from the business and the amount that is required
to be infused in the operations to generate more profit.
 Net Cash Flows is preferred as basis of valuation if any of the
following conditions are present:

• Company does not pay dividends.

• Company pays dividends but the amount paid out
significantly differs from its capacity to pay dividends• Ne
Cash Flows and profits are aligned within a reasonable
forecast period.
• Investor has a control perspective. If an investor can exert
control over a company, dividends can be adjusted based on
the decision of the controlling investor.
Using net cash flows over other cash flow concepts is more advantageous in a
valuation activity since this metric can be directly used as input to a DCF model.
This is not the case for other cash flow or earnings measure such as EBITDA, EBIT,
net income and cash flow from operations since these metrics might have missed
or double counted an item.

• EBITDA and EBIT are both metrics that are before taxes, cash flows that are
available to investors should be after satisfying tax requirements of the
government

• EBITDA and EBIT also do not consider differences in capital structures since it
does not capture interest payments, dividends preference shares and funds
sourced from bondholders to additional investments.

• All these measures also do not consider reinvestment of cash made into the
firm for additional working capital and fixed ass investment that are necessary to
maximize long-term stability of the business.
 In valuation, analysts find analyzing cash flows and its sources helpful in
understanding the following:

• Source of financing for needed investments - Are investments internally

funded by cash generated from operations or debt/equity financing is necessary?
The best case for firms is to fund its investments wholly or partly through cash
from operations. Heavy reliance on external financing from lenders or
shareholders may signal that cash from operations is not enough to support the
firm's long-term stability.

• Reliance on debt financing - Debt financing is an excellent financing strategy

especially for expanding companies. However, it can become a problem for a firm
if its cash from operations is insufficient to repay existing debt obligations. The
situation worsens if firms continuously refinance borrowings that come due by
another borrowing.

• Quality of earnings - Significant disparities between cash flows and income

may indicate earnings does not get converted to cash easy suggesting low
quality.
 1. Net Cash Flow to the Firm – is the
amount made available to both debt and
equity claims against the company.
Two levels
of Net Cash 2. Net Cash Flow to Equity - represents
Flows the amount of cash flows made available
the equity stockholders after deducting
the net debt or the outstanding liabilities
to the creditors less available cash balance
of the company
 Net Cash Flow to the Firm
Net cash flow to the firm refers to the cash flow available to the parties who

supplied capital (1.e. lenders and shareholders) after paying all of expenses,

including taxes, and investing in capital expenditures and working capital as

required by business needs. NCF to the firm is cash flows generated from

operating activities of the business which is intended to pay or return of fund to

the providers. Valuation models based on enterprise value pass cash flows

available to all investors - whether debt or equity.

 Net cash flows to the firm can be computed or derived using the
following approaches.

A. Based from Net Income (or indirect approach)

Net Income Available to Common shareholders PHP XXX
Add: Non-Cash Charges (net) XXX
Add: Interest Expense (net of taxes) XXX
Add/Less: Adjustment in Working Capital XXX
Less: Net Investment in Fixed Capital (Purchases – Sales of Fixed Capital
XXX
Investment)
Net Cash Flow of the Firm PHP XXX

Net Income Available To Common Shareholders:

This is an accounting measure, meaning that non-cash items like depreciation and
amortization is also included as a deduction to arrive at net income. However, this
measure does not include changes in working capital nor capital investments made
during the specific period which significantly affects a firm's cash flows.
Non-Cash Charges (Net).
Pertains to non-cash items that are included in the computation of net income. Analyst
usually look at the statement of cash flows to validate potential non-cash charges. If
amount in the income statement does not match amount reflected in the cash flows
statement, it can be indicative that a portion of that expense is non-cash. The common
noncash items are the following:

• Depreciation and amortization

When a firm acquires a fixed asset like equipment or intangible asset, the initial cash
outflow is made at point of acquisition and is presented in the balance sheet.

• Restructuring charges:
Restructuring refers to the change in the organizational structure or business model of
a company adapt to changing economic climate or business needs. Most restructuring
involves involuntary separation of employees.

• Provisions for Doubtful Accounts:

These are estimated amount to be incurred for the customers inability to pay on time
which is cumulatively account the statement of financial position reported ag accounts
receivable.
 • After-Tax Interest Expense Interest expense (net of any tax savings)
This interest expense is a cash flow intended for the debt providers. In the Philippines,
interest expense is a tax-deductible expense for the company. This means that when
the company pays interest, it reduces tax to be paid.

• Working Capital Adjustment

Also known as working capital, this item represents the net investment in current assets
such as receivables and inventory reduced by current liabilities like payables. The
amount captured is based on the movements in these accounts from prior year.

• Investment in Fixed Capital.

Pertains to cash outflows made to purchase or pay for capital expenditures that are
required to support existing and future operating needs. Capital expenditures range
from property, plant and equipment necessary for production requirements to
intangible assets trademark, patent and copyrights. Firms expect that they will reap
benefits for more than one year as a result of these investments. The investment in fixed
capital assumes that the projects financed acceptable and has positive net present
value.
 Net cash flows to the firm can be computed or derived using the
following approaches.

B. Based from Statement of Cash Flows

Cash Flow from Operating Activities PHP XXX
Add: Interest Expense (net of taxes) XXX
Less: Cash Flow from Investing Activities XXX
Net Cash Flow of the Firm PHP XXX
*only if deducted from the operations

NCF can also be computed using cash flows from operating activities (in the
statement of cash flows) as the starting point. Analysts usually start from this
item since it already considers adjustment for noncash expenses and working
capital investments.
• Cash Flow from Operating Activities
This represents how much cash the company generated from its operations. This shows
how much cash is received from customers and how much cash outflows are paid to
vendors. This also captures changes in current assets and current liabilities. Normally,
this is computed from net income by considering noncash items and working capital
changes. This is considered in computing for NCFF.

• Cash Flow from Investing Activities

This represents how much cash is disbursed (received) for investments in (sale of)
long-term assets like property, plant and equipment and strategic investments in other
companies. This is considered in computing for NCFF. If this section reflects transactions
involving financial assets, this should be excluded.

• Cash Flow from Financing Activities

This represents how much cash was raised (or repaid) to finance the company. This is
not considered when computing NCFF. This is simply because these figures will be
accounted for in the calculation of the Net Cash Flows to the Equity.
 Net cash flows to the firm can be computed or derived using the
following approaches.

C. From Earnings Before Interest, Taxes, Depreciation and

Amortization (EBITDA)
EBITDA, Net of Taxes PHP XXX
Add: Tax Savings on Noncash Charges XXX
Add/Less: Working Capital Adjustments XXX
Less: Investment in Fixed Capital XXX
Net Cash Flow of the Firm PHP XXX

EBITDA or Earnings Before Interest, Taxes, Depreciation and Amortization

pertains to income before deducting interest, taxes, depreciation and
amortization expenses, net of taxes
• Tax Savings on Non-cash Charges
Non-cash charges are not typically adjusted if NCFFS ed if NCFF starts with EBITDA.
However, it is important that analyst should check whether non-cash charges were
already deducted in computing for EBITDA or not. If deducted, then there is a need to
add the item back. If non-cash charges are not yet deducted from EBITDA there is no
need to add it back to compute for NCFF.
 Net Cash Flow to Equity or NCFE
refers to cash available for common
equity participants or shareholders
Net Cash only after paying operating expenses,
satisfying operating and fixed capital
Flow to requirements and settling cash flow
transactions involving debt providers
Equity and preferred shareholders. NCFE can
be computed from NCFF by
considering items related to lenders
and preferred shareholders.
 Net Cash Flow to the Firm PHP XXX
Add: Proceeds from Borrowings XXX
Less: Debt Service XXX
Add: Proceeds from Preferred Share Issuance XXX

Less: Dividends on Preferred Shares XXX

Net Cash Flows to the Equity PHP XXX

• Proceeds from Borrowing

This refers to the amount of cash received by the company as a result of borrowing of long-term debt. Since
NCFF did not include items related to financing, it did not capture cash received by the company from
lenders. Since the cash from the borrowing is with the company already, it is added back to NCFF and
forms part of the cash flow available to common shareholders.

• Debt Service
Debt Service is the total amount used to service the loans or debt financing. This is the total amount of loan
repayment and the interest expenses, net of income tax benefit.

• Proceeds from Issuance of Preferred Shares

Same with the debt, preferred shares as another form of financing, other than the issuance of ordinary
equity, must also be factored in the calculation of the net cash flows available to equity.

• Dividends on Preferred Shares

Since payments made to preferential shareholders in the form of dividends are outflows. This must be
incorporated in the calculation as a reduction of the net cash flows to equity.
 NCFE can be determined under the ff approaches:

A. Based from Net Income ( or indirect approach)

Net Income Available to Common shareholders PHP XXX

Add: Non Cash Change (net) XXX
Add: Interest Expense (net of Taxes) XXX
Add/Less: Adjustment in Working Capital XXX
Less: Net Investment in Fixed Capital (Purchases – XXX
Sales of Fixed Capital Investment)
Net Cash Flow to the Firm XXX
Add: Proceeds from Borrowing XXX
Less: Debt Service XXX
Add: Proceeds from Preferred Shares Issuance XXX
Less: Dividends on Preferred Shares XXX
Net Cash Flows to the Equity PHP XXX
 NCFE can be determined under the ff approaches:

B. From Statement of Cash Flow

Cash flow from Operating Activities PHP XXX

Add: Interest Expense (net of Taxes) XXX
Less: Cash Flows from Investing Activities XXX
Net Cash Flows to the Firm XXX
Add: Proceeds from Borrowing XXX
Less: Debt Service XXX
Add: Proceeds from Preferred Shares Issuance XXX
Less: Dividends on Preferred Shares XXX
Net Cash Flows to the Equity PHP XXX
 NCFE can be determined under the ff approaches:

B. From Earnings Before Interest, Taxes, Depreciation, Amortization (EBITDA)

EBITDA, net of taxes PHP XXX

Add: Tax Savings on Noncash Changes XXX
Add/Less: Working Capital Adjustments XXX
Less: Investment in Fixed Capital XXX
Net Cash Flows to the Firm XXX
Add: Proceeds from Borrowing XXX
Less: Debt Service XXX
Add: Proceeds from Preferred Shares Issuance XXX
Less: Dividends on Preferred Shares XXX
Net Cash Flows to the Equity PHP XXX
Terminal Value

The challenge for the determination of the value of the asset

is to also account economic returns that it will generate in

perpetuity, which is addressed by the terminal value.

Terminal Value represents the value of the company in

perpetuity or in a going concern environment. In practice,

there are several on how to determine the terminal value.

 Basis of Terminal Value

1. Liquidation Value –
Some analysts find that the terminal value be based on the estimated salvage
value of the assets.

2. Estimated Perpetual Value –

Another way to determine the terminal value is by using the estimated farthest
cash flows divided by the cost of capital less the growth rate.
Example:
a company is expecting 15% returns for a venture and assumes that their net cash flows for
the next five years are as follows:

Assuming this is a GCBO, and it is expected that the net cash flows will behave on a normal
trend. The growth rate is computed using compounded annual growth rate formula:
Substituting the given figures, the growth is computed as:

Since the growth rate is 10%, it will be applied on the farthest cash flows i.e. on the 5th year equivalent to
Php7.32, thus the farthest cash flows is now Php8.05 or will substitute the CFn+1. It is now assumed that the
cash flows will continuously growth at the rate of 10% per annum. Thus, the formula can now be applied.
In some cases, that the historical growth pattern is undetermined, some analysts only consider the cost of
capital or their required return to determine the terminal value.

The terminal value in this case is more conservative by about PHP107.

3. Constant Growth
Challenges for some valuators is to determine the amount of required return for
a specific type of asset or investment. In lieu of the required return, they use the
growth rate as the proxy especially if the growth is constant and significant.

4. Scientific Estimates –
Other valuators especially those with vast experience already in some types of
investments uses other basis for them to determine the reasonable terminal
value. Using guesstimates is not prevented because in the end, equity values will
still be based on negotiation

There is no perfect approach to determine the terminal value. The differences in

the appreciation on the determination or even the inclusion of the terminal value
of some risk averse investors is dependent on their risk appetite. This is why
negotiation plays a key role in finalizing the determined value.
Replacement Value Method

The present value of the Net Cash Flows represents the value It may be recalled further that the assets are
financed by debt and equity. Hence, these are the claims which are presented at the Statement of Financial
Position, under an account form of reporting.

The discounted cash flows analysis factors in all the projected streams of cash flows that the project,
opportunity or investment and valuing tit in present time to determine whether the investment made on this
year would be less than the value it will generate in the future, that means the investment yielded an amount
sufficient to cover the investment and allowing the investors to earn more.

DCF Analysis is most applicable to use when the following are available:

• Validated Operational and Financial Information

• Reasonable appropriated cost of capital or required rate of return

• New quantifiable information

Example:

The investment in fixed capital that was purchased and invested in the company amounted to Php100
Million. To be financed by:

• 60% from loan borrowing with an annual interest of 10% payable equally in five years. First payment will be
due after 1 year, and

• 10% preferred shares with 8% coupon rate.

If you are going to purchase 50% of Bagets Corporation, assuming a 15% required return, how much would
you be willing to pay?

Based on the foregoing information, the value of Bagets Corporation equity is Php22.80 Million. If the amount
at stake is only 50% then the amount to be paid is Php11.4 Million (Php22.80 x 50%).
Financial Models in Discounted Cash Flow
Analysis
Financial Modelling is a sophisticated and confidential
activity in a company or for an analyst. Most financial
modelers have extensive financial acumen and vast
knowledge and experience. Financial modelers normally
are economists, financial managers, and accountants.
Management accountants are good candidate for this role
given their ability operational models and design long
term financial strategies.
to develop financial models, the following steps needs to be In order to be
observed:
1. Gather Historical information and references.

This can be generated but not limited to:

Auditing Financial statements

- Its components helps the analyst to assess the future of the company
based on the past events. These are:
* Statement of income - used to determine the historical financial
performance
* Statement of Financial Position - used in determining the book value of
the assets and the disclosed stakes of the debt and equity financiers.
* Statement of Cash flows - Shows how the company historical financing
its operations and investments.
* Statement of changes in stockholders' equity - Shows the information
about the claims and dividend background of the company.
* Notes to FS - shows the summary of the important disclosures that is
that should be considered in the valuation.
Corporate Disclosure
- Provide more context for the future plans and strategies of the
company. It enables the analysts to identify the risks and quantify
them accordingly. This is shown to the public, the difference is their
perception about the risks.
- Since contracts are formal agreement between parties, it is
important for the modeler to know the covenants contained by it.
Gathering such information is important to have a reasonable basis to
quantify and incorporate it in the financial model.

Peer Information
- It provides context and supports the risks identified or will be
assumed in the valuation process. Peers can be other analysts,
experts etc. however sharing of information is prohibited by the law.
The financial model must be able to filter the information that would
be only necessary or relevant to the valuation.

2. Establish drivers for growth and assumptions

- Drivers and assumptions can be established by conducting

financial analysis. It is suggested to be those validated and is
presented by authorities. It can be found to the government websites
or disclosed to the public through media that has a wider reach and
scale.
 Inflation - result of the movement from the
prices from a year to another.
This is computed using this formula:

Growth
Indicators
 Consumer Price Index – represents the price of the
basket of commodities for particular period. In financial
modeling, you need the inflation to be used as driver for
certain operating and capital expenditures.
Growth Two ways to compute the value:

Indicators 1. * Nominal Financial Models - Prices stated in this

model already assumes that the prices grew or
decline, in the case of inflation or deflation.

2. * Real Financial Models - It preserves the price of the

operating as well as the capitals expenditure as if no
changes in the prices occurs.
 Population Growth rate - it is factored in to serve
as a growth driver for the demand of the product
Growth specifically for the merchandising
manufacturing kind of business.
or

Indicators The formula for the computation of the

population growth rate is similar with inflation,
except that the input in the population count in
particular segment is in 8 particular year.
- Financial ratios maybe used also as a tool to determine the growth drivers
and assumptions. Trend trajectory will also help you to establish the
trajectory of the growth pattern. This patter must be asses by the financial
modeler whether the company can sustain the pattern otherwise it is
conservative to assume a less aggressive growth .

3. Determining the reasonable cost of capital

- the cost of capital reasonable for the valuation is determined by
the weighted cost of debt and cost of equity.

4. Apply the formulae to compute for the value

- Normally, the value is calculated through the use of DCF. Since most
of the information are already available in the financial model, it is easier to
use other capital budgeting techniques like Internal rate of return,
profitability index etc.
5. Make scenarios and sensitivity analysis based on the results

- Advantage of having a financial model is that you can easily tweak the
given information and get the results immediately. It is similar to scenario
model, except that sensitivity analysis will have to select driver or few
drivers, ceteris paribus, and check the degree of the change it will cause to
the result.
Components of Financial Model
A financial model should be understandable, printable and auditable. The
financial model should be designed in a way that the investor or the client
of the analysts or the proponent themselves can understand the dynamics
and follow the drivers to enable them to have a better appreciation and
sound judgment of the results.

As a quick guide in developing a financial model the following componen

are recommended, particularly when using Microsoft Excel:

• Title Page
This provides an overview and the project being valued or assessed. This
includes also necessary information to secure the prop rights of the modeler
or the firm he or she is working with. include data cut-off to serve as a guide
to the readers.
• Data Key Results
This sheet summarizes the results of the study. This will serve as the
dashboard to enable the modelers to analyze the result and to facilitate the
readers' appreciation on the results of the project. This also facilitate
preparation of pertinent reports.

This also contains the valuation results, scenarios, sensitivity analysis. Graphs
can also be found in this sheet.

• Assumption Sheet
This sheet summarizes the assumptions used in the model. This is normally
an input sheet where all inputs should be made. The information that can
be found in this sheet must be linked to all the output sheets like Pro-forma
Financial Statements. Supporting Schedules and Data Key Results.
− Pro-forma Financial Statements
− This presents the 3 components of the financial statements namely:
Statement of Income, Statement of Financial Position and Statement of
Cash Flows. In this sheet, you can also find some key financial ratios
particularly those that has to do with financial performance and
efficiency ratios.

− Some modelers also find it convenient to have their valuation

computation be done in this sheet since the inputs of cash flows are
already available here.

− Supporting Schedules
− This is like a subsidiary ledger which provides supporting computation
to the components of the pro forma financial statements. There is no
limit for the supporting schedules the only challenge is that the
electronic financial models consume large amount of data because of
the supporting schedules