CHAPTER 5: DISCOUNTED CASH FLOWS
METHOD
- The way to determine the value of an investment
opportunity is by determining the actual cash
generated by a particular asset.
- DCF analysis can be done by determining the PV
of the net cash flows of the investment opportunity.
- In CFAS, it was discussed that cash flows are
presented and analyzed based on their sources and
activities which are categorized as:
o Operating
o Investing
o Financing
- In determining the value of an asset, the cash flows
are important reference or inputs.
 It is essential to include amount of cash that
will be available for the claims of the
equity owners.
- 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 GBCO, 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 for more profit.
- NCF is preferred as a basis of valuation if any of
the following conditions are present:
o Company does not pay dividends
o Company pays dividend but the amount
paid out significantly differs from its
capacity to pay dividends
o NCF and profits are aligned within a
reasonable forecast period.
o Investor has control perspective. If an
investor can exert control over a company,
dividends can be adjusted based on the
decision of the controlling investor.
- Using NCF over other cash flows 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.
- In valuation, analysts find analyzing cash flows and
its sources helpful in understanding the following:
1.) Sources of financing for needed
investments
 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.
2.) 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 situations worsens if firms
continuously refinance borrowings
that come due to another
borrowing.
3.) Quality of earning
 Significant disparities between
cash flows and income may
indicate earnings does not get
converted to cash easily,
suggesting quality.
- There are two levels of NCF:
a.) Net Cash Flows to the Firm
b.) Net Cash Flows to Equity
Net Cash Flow to the Firm
- The cash flow available to the parties who supplied
capital (lenders and shareholders) after paying all
operating expenses, including taxes, and investing
in capital expenditures and working capital as
required by the business needs.
- Are cash flows generated from operating activities
of the business which is intended to pay a required
return of fund providers.
 NOTE: Valuation models based on
enterprise value encompass cash flows
available to all investors – whether debt
or equity.
- ENTERPRISE VALUE – refers to the theoretical
value of its core business activities as reflected by
its net cash flows.
- Net cash flow only captures items that are directly
related to the operating and investing activities of
the business.
- Consequently, NCF excludes items associated with
financing activities.
 - NCF to the firm can be computed or derived using
the following approaches:
A.) Based on Net Income (or indirect approach)
Net Income Available to Common Shareholders P XX
Add: Non-Cash Charges (net)
Add: Interest Expense (net of Taxes)
Add/Less: Adjustment in Working Capital
Less: Net Investment in Fixed Capital
(Purchases – Sales of Fixed Capital Investment)
Net Cash Flows to the Firm P XX
o Net Income Available to Common Shareholders
- Basic measure of a firm’s profitability
- Bottom line figure in an income statement.
- This is the cost left for the shareholders after
deducting all costs, expenses, depreciation,
amortization, interest, taxes, and dividends to
preferred shareholders.
 Non-cash items like depreciation and
amortization are also included as a
deduction to arrive at net income.
 This measure does not include changes in
working capital nor investments made
during the specific period that
significantly affects a firm’s cash flows.
o Non-Cash Charges (net)
- Pertains to non-cash items that are included in the
computation of net income.
- Analysts usually look at the Statement of Cash
flows to validate potential non-cash charges.
- Amount in income statement ≠ amount in SOCF =
non-cash expense.
- Examples:
 Depreciation and amortization
 When a firm acquires a fixed
asset (equipment or intangible),
the initial outflow is made at the
point pf acquisition and is
presented in the balance sheet.
 In succeeding periods, a portion
of the initial cash outflow is
recorded as depreciation and
amortization which reduces net
income, despite not having
actual cash outflow.
Should be added back to
arrive at the real cash
flow.
 Restructuring charges
 Restructuring – refers to the
change in the organizational
structure or business model of a
company.
 Restructuring >> involuntary
separation of employees >>
severance pay >>outright cash
flows.
 Provisions for Doubtful Accounts
XX  These are estimated amounts to
be incurred for the customer’s
XX
inability to pay on time
XX  Cumulatively accounted under
XX the statement of financial
position.
 Not yet written off = there is a
positive chance that it can still be
collected
Should be added back to
the net income
attributable to common
shareholders.
o After – Tax Interest Expense (net of any tax savings)
- This interest expense is a cash flow intended for the
debt providers.
- Interest expense is a tax-deductible expense
 when interests are paid, it reduces
the tax to be paid.
 Cash outflow = Interest Expense
– Tax Savings
- Added back to net income – the objective of NCF
is to measure the cash flows associated with the
operating activity of the business.
- The impact of financing should be neutralized to
arrive at the real business value based on its
operations.
o Working capital Adjustment
- Also known as working capital
- This item represents the net investment un current
asset such as receivables and inventory reduced by
current liabilities like payables.
WCA = Current Asset – Current Liabilities
- The amount captured is based on the movements in
these accounts from prior year.
- Required investment in current assets tend to
increase when a firm’s sales grow consistently year
on year.
Increase in Current Assets = Cash out flow
Higher Current Liabilities = Cash inflows
- Companies do not need to pay for axes when they
are investing in their operational capital
- On the other hand, if current assets requirement
declines, this means that more cash is available to
debt and equity providers, thus added back.
- For NCF and valuation purposes, movements in
cash, marketable securities short-term payable and
 current portion of the long-term debt is
EXCLUDED in the computation.
 CASH – is excluded since the purpose of
the NCF exercise is to identify what is the
real cash flow of the business.
 MARKETABLE SECURITIES – are
also excluded since these are not directly
linked to operations
 NOTES PAYABLE – are excluded since
they are associated with the financing side
of the business.
o 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 PPE
necessary for production requirements to
intangible assets like trademarks, patent
and copyrights.
 NOTE: increases in fixed capital
investments use cash, hence a reduction to
Net Cash Flow.
 This is captured in the year that the cash
flow is made. Information related to these
can be found in the balance sheet and
statement of cash flows.
- When gaps exist between amount of capital
investment and depreciation ((called as net capital
expenditures), this is usual related to the growth
profile of the company.
o Cash paid for acquisition of a new business
also falls into this category.
 The full purchase amount reduces the
NCF in the year of acquisition.
o Sale of capital expenditures that occurred
 This should be added back to the NCF
 This sales increase the cash inflow
which consequently reduces the
investment in fixed capital for that
period.
- Net investment in fixed capital is deducted to arrive
at NCF computation.
 NOTE: A negative net investment
signifies that firm received cash since it
sold more assets than it purchased for the
year.
 non-cash charges were already deducted in
B.) From Statement of Cash Flows
- NCF can also be computed cash flows from
operating activities (in the statement of cash flows)
as the starting point.
Cash flow from Operating Activities P XX
Add: Interest Expense (net of Taxes) * XX
Less: Cash Flows from Investing XX
Activities
Net Cash Flows to the Firm P XX
* only if deducted from the operations
o 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 flows are paid to
vendors.
 Captures changes in current assets and
current liabilities.
 This is considered in computing for
NCFF.
o Cash flow from investing activities.
- This represents how much cash is disbursed
(received) for investments in (sale of) long-term
assets PPE and strategic investments in other
companies.
 If this section reflects transactions
involving financial assets, this should be
excluded.
 This is considered in computing for
NCFF.
o Cash flow from financing activities.
- This represents how much cash was raised (or
repaid) to finance the company.
 This is considered in computing for
NCFF.
C.) From Earnings Before Interest, Taxes, depreciation
and Amortization (EBITDA)
EBITDA, net of Taxes P xx
Add: Tax Savings on Noncash Charges xx
Add/ Less: Working Capital xx
Adjustments
Less: Investment in Fixed Capital xx
Net Cash Flows to the Firm P xx
o EBITDA, net of Taxes
- Pertains to income before deducting interest, taxes,
depreciation, amortization expenses, net of taxes.
- The NCFF should only consider the amount net of
the applicable taxes to be paid.
 This is to conservatively show the
EBITDA at the amount net to be realized
by the investor.
o Tax Savings on Non-cash Charges
- It is important that analysts should check whether
computing for EBITDA or not.
 If deducted – there is a need to add the
item back
 If not yet deducted - there is no need to
add it back to compute for NCFF.
  NOTE: Instead of adjusting for the full - Since payments made to preferential shareholders
amount, analyst should add back the in the form of dividends are outflows. This must be
corresponding tax savings related to this incorporated in the calculation as a reduction of the
non-cash charges to EBITDA. NCFE.

Net Cash Flow to Equity - NCFE can be determined under the following
approaches:
- NCFE – refers to cash available for common
A.) Based from Net Income (or indirect approach)
equity participants or shareholders only after:
 paying operating expenses Net Income Available to Common Pxx
Shareholders
 satisfying operating and fixed capital
Add: Non-Cash Charges (net) xx
requirements and
Add: Interest Expense (net of Taxes) xx
 settling cash flow transactions involving Add/Less: Adjustment in Working xx
debt providers and preferred shareholders. Capital
- NCFE signifies the level of available cash that a Less: Net Investment in Fixed Capital xx
business can freely declare as dividends to its (Purchases – Sales of Fixed
common shareholders. Capital Investment)

Net
Net Cash CashtoFlows
Flows to the Firm
the Firm xx xx
o Proceeds from Borrowing
Add: Proceeds from Borrowing xx xx
Add: Proceeds from Borrowings
- This refers to the amount of cash received by the Less: Debt Service xx xx
Less: Debt Service
company as a result of borrowing of long-term Add: Proceeds from Preferred Shares xx
Add: Proceeds
Issuancefrom Preferred Share Issuance
debt. xx
- Since the cash from borrowing is with the Less: Dividends on Preferred Shares
company already, it is added back to NCFF and Less: Dividends on Preferred Shares xx
Net cashNET CASH
Flows FLOWS
to the Equity TO THE EQUITY xx
Cash Flows from Operating Activities Pxx

Add: Interest Expense (net of Taxes) xx

Less: Cash Flows from Investing Activities xx

Net Cash Flows to the Firm xx
Add: Proceeds from Borrowing xx
B.) From Statement of Cash flows
Less: Debt Service xx

Add: Proceeds from Preferred Shares Issuance xx C.) From Earnings Before Interest, Taxes,
depreciation and Amortization (EBITDA)
Less: Dividends on Preferred Shares xx

NET CASH FLOWS TO THE EQUITY xx

EBITDA, net of Taxes Pxx
forms part of the cash flow available to common
shareholders. Add: Tax Savings on Noncash Charges xx

o Debt Service Add/Less: Working Capital Adjustments xx

- is the total amount used to service the loans or debt Less: Investment in Fixed Capital xx
financing.
- This is the total amount of loan repayment and the Net Cash Flows to the Firm xx
interest expense, net of income tax benefit.
Add: Proceeds from Borrowing xx
 NOTE: the interest expense is considered
as part of the financing activities and Less: Debt Service xx
hence, deducted from NCF since this is
associated with long-term debt of the Add: Proceeds from Preferred Shares xx
company. Issuance

Less: Dividends on Preferred Shares xx

o Proceeds from issuance of Preferred Shares
- Same with debt, preferred shares as another form NET CASH FLOWS TO THE EQUITY xx
of financing, other than the issuance of ordinary
equity, must also be factored in the calculation of
he ne cash flows to equity.
TERMINAL VALUE
o Dividends on Preferred Shares
 - The risk and returns are inherent to the opportunity
at the end of the projection period should also be
quantified.
- Terminal Value – represents the value of the
company in perpetuity or in a going concern
environment.
- Basis of Terminal Value
1.) Liquidation Value
o Some analysts find that the terminal value
be based on estimated salvage value of the
assets.
2.) Estimated Perpetual Value
o Another way to determine the terminal
value is by using the farthest cash flows
you can estimate divided by the cost of
capital less the growth rate.
3.) Constant Growth
o In lieu of the required return, they use the
growth rate as a proxy especially if the
growth is constant and significant.
4.) Scientific Estimates
o using guesstimates is not prevented
because in the end, equity values will still
be based on negotiations.
FINANCIAL MODELS IN DCF ANALYSIS
- Financial Modelling – is a sophisticated and
confidential activity in a company of for an analyst.
 NOTE: Information can also be
considered as a competitive advantage of a
company or a person.
- Most financial modelers have extensive financial
acumen and vast knowledge and experience.
- Financial modelers normally are economists,
financial managers, and accountants.
o Management Accountants are good
candidate for this role given their ability to
understand operational models and design
long term, financial strategies.
- In order to develop financial model, the following
steps needs to be observed:
1.) Gather historical information and references
- Historical information must be made available
before the financial model is to be constructed.
o Historical information may be generated
from, but not limited to the following:
a.) Audited Financial Statements – are the most
ideal reference for the historical performance
of the company.
– used by the financial modelers to assess
the future of the company based on its past
performance.
 Statement of Income – used to
determine the historical financial
performance.
2.) Establish drivers for growth and assumptions
 Statement of Financial Position
– is used to determine the book
value of the assets and the
disclosed stakes of the debt and
equity financiers
 Statement of Cash Flows – will
illustrate how the company
historically financing it
operations and investments.
 Statement of Changes in Equity
– provides the information on
how much is the claim and
dividend background of the
company.
 NOTE: One of the most important
components of the financial statements are
the notes to the financial statements.
 It provides the summary of important
disclosure that should be considered in the
valuation.
b.) Corporate disclosures – provide more context
for the future plans and strategies of the
company.
– This will enable the analysts or the
financial modelers to identify the risks about
the GCBO and quantify them accordingly.
c.) Contracts – are formal agreements between
parties.
– In valuing the GCBOs, it is important
for the modeler to also know the existing
contracts and the covenants contained in it.
– Due diligence is necessary to verify any
contingent liability and other legal risks
surrounding that opportunity and quantify it
accordingly to have amore conservative value.
d.) Peer information and other public
information – are also essential inputs to the
financial model.
– provides more context and even supports
the risks identified or will be assumed in the
valuation process.
- Collectively, the financial model must be able to
filter the information that would b necessary for the
valuation.
- Relevance and reliability of information are
important.
 NOTE: Not all information should be
given consideration.
- Materiality is another consideration
o Even if there are additional information
gathered, there should be a sense of
materiality assessment involved.
o Only relevant items should be considered
in valuation.
 - Once all relevant information was gathered and
validated, drivers and assumptions can be
established by conducting financial analysts.
- Drivers – are suggested to be those validated and is
represented by authorities like government or
experts.
- Growth drivers – are normally based on
population, since most of the businesses are
consumer goods.
3.) Determine the reasonable cost of capital
- In determining the reasonable cost of capital, the
financial modeler must be able to use the
appropriate parameters for the company.
- Generally, cost of debt and cost of equity are
weighted to determine the cost of capital
reasonable for the valuation.
- Key financial ratios can also be found in this sheet,
especially those that has to do with financial
performance and efficiency ratios.
5.) 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 schedule.

4.) Apply the formula to compute for the value

5.) Make scenarios and sensitivity analysis based on the
results.
- The advantage of having a financial model is that
you can easily tweak the given information and get
the results immediately.

COMPONENTS OF FINANCIAL MODEL

1.) Title Page

- This provides an overview and the project being
valued or assessed.
- This includes also necessary information to secure
the proprietary rights of the modeler or the firm he
or she is working with.

2.) Data Key Results

- This sheet summarizes the results of the study.
- This will serve as the dashboard to enable the
modelers to analyze the results and to facilitate the
readers’ appreciation on the results of the projects.
o Contains the valuation results, scenarios,
and sensitivity analysis.
o Graphs can also be found in this sheet.

3.) Assumption Sheet

- This sheet summarizes the assumptions used in the
model.
- This is normally an input sheet where all inputs
should be made.
o The information that can be found in this
sheet must be linked to all the output
sheets like Pro-forma FS, Supporting
Schedules and Date Key Results.

4.) Pro-forma Financial Statement

- This represents the 3 components of the financial
statements:
o Statement of Comprehensive Income
o Statement of Financial Position
o Statement of Cash Flows