Chapter 4

Other DCF Models

 Outline

 Enterprise DCF Model

 Equity DCF Model
 Adjusted Present Value (APV) Model
 Economic Profit Model
 Accounting for Value
 Maintainable Profits Method
 Enterprise DCF Model
The enterprise DCF Model is the standard DCF
model used commonly in valuation practice.
Advantages
1. It incorporates the costs and benefits of
borrowing in an easily understandable manner.
2. The impact of changes in financial leverage on
firm value can be readily examined
Problems
3. Intuitively, it is easier to understand the free cash
flows to equity than the free cash flows to the firm
4. The calculation of weighted average cost of
capital calls for making implicit assumptions that
may not be reasonable.
 Equity DCF Model

 Dividend discount model

 Free cash flow to equity model
 DIVIDEND DISCOUNT MODEL
• SINGLE PERIOD VALUATION MODEL
D1 P1
P0 = +
(1+r) (1+r)
• MULTI - PERIOD VALUATION MODEL
 Dt
P0 = 
t=1 (1+r)t
• ZERO GROWTH MODEL
D
P0 =
r
• CONSTANT GROWTH MODEL
D1
P0 =
r-g
 Centre for Financial Management , Bangalore
 TWO - STAGE GROWTH MODEL

1- 1+g1 n

1+r Pn
P0 = D1 +
r - g1 (1+r)n
WHERE
Pn D1 (1+g1)n-1 (1+g2) 1
=
(1+r)n r - g2 (1+r)n

 Centre for Financial Management , Bangalore

 TWO - STAGE GROWTH MODEL : EXAMPLE
EXAMPLE THE CURRENT DIVIDEND ON AN EQUITY SHARE OF
VERTIGO LIMITED IS RS.2.00. VERTIGO IS EXPECTED TO ENJOY AN
ABOVE-NORMAL GROWTH RATE OF 20 PERCENT FOR A PERIOD OF 6
YEARS. THEREAFTER THE GROWTH RATE WILL FALL AND STABILISE
AT 10 PERCENT. EQUITY INVESTORS REQUIRE A RETURN OF 15
PERCENT. WHAT IS THE INTRINSIC VALUE OF THE EQUITY SHARE OF
VERTIGO ?
THE INPUTS REQUIRED FOR APPLYING THE TWO-STAGE MODEL ARE :
g1 = 20 PERCENT
g2 = 10 PERCENT
n = 6 YEARS
r = 15 YEARS
D1 = D0 (1+g1) = RS.2(1.20) = 2.40

PLUGGING THESE INPUTS IN THE TWO-STAGE MODEL, WE GET THE

INTRINSIC VALUE ESTIMATE AS FOLLOWS :

1.20 6
1 -
1.15 2.40 (1.20)5 (1.10) 1
P0 = 2.40 +
.15 - .20 .15 - .10 (1.15)6

1 - 1.291 2.40 (2.488)(1.10)

= 2.40 + [0.497]
-0.05 .05

= 13.968 + 65.289
= RS.79.597

 Centre for Financial Management , Bangalore

 THREE STAGE GROWTH MODEL – 2
Expected Growth in the Three-Stage Dividend Discount Model

Earnings Growth Rate

ga

gn

High Declining Infinite Stable Growth

Growth Growth

Dividends
High Payout Ratio

Increasing Payout Ratio

Low Payout Ratio
 H MODEL

ga

gn

H 2H

D0
PO = [(1+gn) + H (ga - gn)]
r - gn
D0 (1+gn) D0 H (ga - gn)b
= +
r - gn r - gn

VALUE BASED PREMIUM DUE TO

ON NORMAL ABNORMAL GROWH
 ILLUSTRATION : H LTD

D0 = 1 ga = 25% H=5
gn = 15% r = 18%
1 (1.15) 1 x 5(.25 - .15)
P0 = +
0.18 - 0.15 0.18 - 0.15
= 38.33 + 16.67 = 55.00
IF E = 2 P/E = 27.5

 Centre for Financial Management , Bangalore

 Applicability of the Dividend
Discount Model
Advantages
 It is simple and intuitively appealing
 Fewer assumptions are required to forecast
dividends than to forecast free cash flows.
 Firms generally pursue a smoothed dividend
policy

Limitations
 Firms may build cash balances (on which equity
shareholders have a claim but not pay dividends)
 FREE CASH FLOW TO EQUITY (FCFE) VALUATION
So far our focus was on valuing the firm (or the enterprise) as a whole. If you are
interested in determining the equity value, you can derive it as follows:
Equity value = Firm value – Debt value
Alternatively, you can look at the free cash flow to equity (FCFE) and discount it
at the cost of equity.
The FCFE is the cash flow left for equity shareholders after the firm has covered
its capital expenditure and working capital needs and met all its obligations
toward lenders and preference shareholders. It is defined as follows:
FCFE = (Profit after tax – Preference dividend)
- (Capital expenditure – Depreciation)
- (Change in net working capital)
+ (New debt issue – Debt repayment)
+ (New preference issue – Preference repayment)
- (Change in investment in marketable securities)
The equity value is the present value of the FCFE stream, where the discounting
rate is the cost of equity (rE)
 FCFEt
Equity value =  (32.4)
t=1 (1+ rE)t
 Centre for Financial Management , Bangalore
 MATRIX LIMITED DATA
To illustrate the FCFE valuation, let us look at the data for Matrix Limited for year 3, the year
that has just ended, and for the next five years, years 4 through 8. This data has been extracted
from Exhibits 32.3 and 32.5.

 Centre for Financial Management , Bangalore

 FCFE FORECAST
The FCFE forecast for the explicit forecast period, years 4
through 8, is worked out below:

 Centre for Financial Management , Bangalore

 FCFE VALUATION
To understand the above numbers remember the following accounting identities:
Change in net fixed assets = Capital expenditure – Depreciation
Change in debt = New debt issue – Debt repayment
If we assume that the FCFE grows at a constant rate of 10 percent per year after the
explicit forecast period, the equity value using the FCFE valuation method can be
calculated as follows:

 Centre for Financial Management , Bangalore

 Adjusted Present Value Model

In a situation where the capital structure of the firm is likely to substantially

change over time, the adjusted present value (APV) is more appropriate.

According to the APV approach

Value of the Value of the
Enterprise value = unlevered equity + interest tax
free cash flows shields

The first component on the right hand side of the above equation is the
present value of the firm’s operating cash flows. Since the operating cash
flows do not depend on how the firm is financed, they may be referred to
as the unlevered equity free cash flows. The second component on the
right hand side of the above equation is the present value of the interest
tax shields arising from the use of debt financing. By decomposing the
enterprise value in this way, the APV approach captures easily the impact
of changing capital structure.
 Step in Implementing the APV
Approach
1. Estimate the present value of the cash flow during
the planning period. The planning period cash flow
comprises of (a) unlevered equity free cash flow and
(b) interest tax shield.
The unlevered equity free cash flow is the same as the
free cash flow to the firm.
So,
The present value of the cash flow during the planning
period is:

n FCFFt n It x T
 + 
t=1 (1 + rUE)t t=1 (1 + rD)
Step 2 : Estimate the terminal value of the firm at the end of the
planning period.

The terminal value of the firm at the end of the planning period is:

FCFFn (1 + g)

WACC - g

where FCFFn is the free cash flow to firm at the end of the planning period,
g is the perpetual growth rate in FCFF beyond the planning period, and
WACC is the weighted average cost of capital, beyond the planning period.

Note that the above formula for the terminal value of the firm at the end
of the planning period assumes that: (a) after the planning period, the
capital structure of the firm remains constant, and (b) the firm’s cash
flows beyond year n would grow at a constant rate of g which is less than
WACC.
Step 3 : Add the present values of cash flows
during the planning period and terminal value
The enterprise value, as per the APV approach,
is:
Present value
of planning n FCFFt n It x T
period cash : ∑ + ∑
Flows t = 1 (1 + rUE)t t = 1 (1 + rD)t
+

FCFFn (1+g) 1 n
Present value of the
terminal value :
WACC – g 1 + rUE
You have developed the following projections for Optex Limited :
in million
Years
1 2 3 4 5
 Free cash flow to the firm 200 250 300 340 380
 Interest-bearing debt 500 400 300 200 100
 Interest expense 60 48 36 24 12

Calculate the enterprise value of Optex Limited using the

following assumptions:

 Beyond year 5, the free cash flow to the firm of Optex will grow at a constant
rate of 10 percent per annum.
 Optex’s unlevered cost of equity is 14 percent.
 After year 5, Optex will maintain a debt-equity ratio of 4:7.
 The borrowing rate for Optex will be 12 percent.
 The tax rate for Optex is 30 percent.
 The risk-free rate is 8 percent.
 The market risk premium is 6 percent.
 The present value of the unlevered equity free cash flow (which is the
same as the free cash flow to firm) during the planning period is:

n FCFFt 200 250 300 340 380

∑ = + + + + = 969 million
t = 1 (1 + rue)t (1.14) (1.14) 2
(1.14)3 (1.14)4 (1.14)5

The present value of the interest tax shield during the planning period is:
n It x T 60 x 0.3 48 x 0.3 36 x 0.3 24 x 0.3 12 x 0.3
 = + + + + = 41.9 million
t = 1 (1 + rD)t (1.12) (1.12)2 (1.12)3 (1.12)4 (1.12)5

The present value of the terminal value at the end of the planning period is :
FCFFn (1 + g) 1 n

WACC – g 1 + rUE

380(1.10 ) 1 5

= 6220.5 million
0.1349 – 0.10 1.14

Hence the enterprise value of Optex Limited is:

969.0 + 41.9 + 6220.5 = 7231.4
 It may be noted that the WACC value of 15.24 percent used above has
been arrived as follows.

1. Given that is rUE is 14 percent, UE, the unlevered equity beta, was calculated by
solving the following equation:

rUE = Risk-free rate + UE x Market risk premium

14 = 8 + UE x 6

UE = 1

2. Given UE = 1, LE, the levered equity beta was calculated:

LE = UE[ 1 + D/E (1-T)]

= 1 [1+4/7 (1-0.3)]
= 1.4

3. Given LE= 1.4, rLE, the cost of levered equity was calculated:

rLE = 8 + 1.4 x 6 = 16.4 percent

4. Given rLE = 16.4 percent, WACC, the weighted average cost of capital was calculated.
WACC = 7/11 x 16.4 + 4/11 x 12 x (1 – 0.3)
= 10.44 + 3.05
= 13.49 percent
 Economic Profit Model
The enterprise DCF model is endorsed by academics
and practitioners alike because it focuses squarely on
cash flows in and out of the business. However, it has
a shortfall in the sense that the cash flow of a single
year hardly provides any insight into the
performance of the firm. A declining free cash flow
may mean deteriorating performance or investment
for future returns. In this respect, the economic profit
model is more informative. While it produces a
valuation that is identical to that of the enterprise
DCF model, it also gives a clear picture of how and
where the firm creates value.
 Economic profit (EP) is simply the surplus left after making an appropriate
charge for the capital invested in the business. The EP of a single period is
defined as:

EP = IC x (ROIC – WACC)

where IC is the invested capital, ROIC is the return on invested capital, and WACC
is the weighted average cost of capital.
Since ROIC is equal to NOPLAT (net operating profit less adjusted taxes)
divided by IC, we can rewrite the equation for EP.

EP = NOPLAT - IC x WACC

According to the EP model, the value of a firm (Vo) is equal to the current
invested capital plus the present value of the future economic profit stream. In
symbols

 ICt-1 x ( ROICt- WACC)

Vo= ICo + 
t= 1 (1+WACC)t
Equivalence of the Enterprise DCF Model and
the EP Model
Global Limited has an invested capital of Rs.50 crore. Its return on invested
capital (ROIC) is 12 percent and its weighted average cost of capital (WACC) is 11
percent. The expected growth rate in Global’s invested capital will be 20 percent
for the first three years, 12 percent for the following two years, and 8 percent
thereafter for ever. The forecast of Global’s free cash flow is given in Exhibit 4.5.

Free Cash Flow

in million
Year 1 2 3 4 5 6 7
Invested capital (Beg) 50.00 60.00 72.00 86.40 96.77 108.38 117.05
NOPLAT 6.00 7.20 8.64 10.37 11.61 13.00 14.05
Net Investment 10.00 12.00 14.40 10.37 11.61 8.67 9.36
Free cash flow (4.00) (4.80) (5.76) - - 4.33 4.69
Growth rate (%) 20 20 20 12 12 8 8
The present value of free cash flow (FCF) during the planning period is:

-4.00 - 4.80 -5.76 0 0 4.33

PV (FCF) = + + + + + = 9.4crore
(1.11) (1.11) 2
(1.11)3 (1.11)4 (1.11)5 (1.11)6

The horizon value at the end of six years, applying the constant growth model,
is:

FCFH +1 4.68
VH = = = 156.0 crore
WACC-g 0.11-0.08

The present value of VH is:

156.0
= 83.4 crore
(1.11)6

Adding the present value of free cash flow during the planning period and
present value of horizon value, gives the enterprise DCF value:

V0 = - 9.4 + 83.4 = 74.0 million

 Let us now value the Global Limited using the EP approach under the same set of assumptions. The projected EPs for 7
years are shown in Exhibit 4.6

EP Projection
in million
Year 1 2 3 4 5 6 7
Invested capital (Beg) 50.00 60.00 72.00 86.40 96.77 108.38 117.05
NOPLAT 6.00 7.20 8.64 10.37 11.61 13.00 14.05
Cost of capital (%) 11 11 11 11 11 11 11
Capital charge 5.50 6.60 7.92 9.50 10.64 11.92 12.88
EP 0.50 0.60 0.72 0.87 0.97 1.08 1.17
Growth rate (%) 20 20 20 12 12 8 8
The present value of the EP stream is :

0.50 0.60 0.72 0.87 0.97 1.08 1.17 1

+ + + + + + x = 24.0 million
(1.11) (1.11)2 (1.11)3 (1.11)4 (1.11)5 (1.11)6 (0.11 – 0.08) (1.11)6

Adding the invested capital to the present value of EP stream gives the enterprise value:

Vo = 50 + 24 = 74 crore

Thus, the two models lead to identical valuation.

 ACCOUNTING FOR VALUE
Value of equity = Book value + Value attributable to superior returns.
Suppose, we look at forecast earnings and book value over the next three
years. Then,

(ROE1 – r ) x Bo (ROE2 – r ) xB1 (ROE3– r ) xB2

Value of equityo = Bo+ + +
1+r (1+r)2 (1+r)2 (r-g)

Residual earnings1 Residual earnings2 Residual earnings3

= Bo+ + +
1+r (1+r)2 (1+r)2 (r-g)

Where Bo is the current book value of equity, ROEt, is the book rate of
return on equity defined as expected earnings in year t divided by expected
book value in year t-1, r is the return required by equity investors, and g is
the rate at which residual earnings are expected to grow after year 3.
 RESIDUAL EARNINGS MODEL
The residual earnings model is equivalent to the dividend discount model for going
concerns. So it is congruent with the principle that value is the present value of expected
dividends.
The residual earnings model can be rearranged as follows:
Dividend1 Dividend2 B2 (ROE3 – r) B2
Value of equityo = + + +
1+r (1+r)2 (1+r)2 (1+r)2 (r-g)
Example The various valuation metrics for Maxima Limited for year 0,1,2, and 3 are as
follows: 0 1 2 3
• Book value per share (BPS) 100 111 122.66 134.93
• Book return on equity (ROE) 22% 21% 20%
• Earnings per share (EPS) 22 23.31 24.53

11 11.65 12.26

7 6.66 6.13

Beyond year 3, the ROE will be 20 percent, the required return by equity investors will be
15 percent, and the growth rate will be 10 percent. What ill be the value of equity?
The value of equity as per Eq (4.28) is:

(0.22 – 0.15 )x100 (0.21 – 0.15)x111 (0.20 – 0.15 ) x 122.66

Value of equity 0 = 100 + + +
1.15 (1.15)2 (1.15)2 (0.15 – 0.10)
= 100+ 6.09 + 5.04 + 92.75
= 203.88
The value of equity as per Eq (4.29) is :
11 11.65 122.66 (0.20 – 0.15) x 122.66
Value of equity 0 = + + +
1.15 (1.15)2 (1.15)2 (1.15)2 (0.15- 0.10)
 APPLICATION OF RESIDUAL EARNINGS MODEL

In his book Accounting for Value, Stephen Penman illustrates the residual
earnings approach using the following financial numbers of Microsoft
after it published its annual report for the fiscal year ending June 30,
2008.
• Price per share  $ 25
• Market capitalisation  $ 228.8 billion
• Book capital  $ 36.286
billion
• Net operating assets  $ 12.624 billion
• Cash  $ 23.662
billion
• After- tax operating income from the business  $16.835 billion
• Interest income after taxes $ 846 million
• Total net income  $ 17.681 billion
Assuming a 9 percent discount rate and applying a residual earnings no-growth valuation,
Penman estimated the equity value as follows:
Equity value = Value of operation + Value of cash
Residual operating income 2009
= Net operating assets 2008 + + Cash 2008
0.09
16.835 - (0.09 x 12.624)
= 12.624 + + 23.662
0.09
 MAINTAINABLE PROFITS METHOD

• Average Future Maintainable Profits

 Calculation of Past Pre- tax
Average Profits
 Projection of Future Pre- tax
Maintainable Profits
• Rate of Capitalisation
 Applicability of DCF
The DCF method requires credible estimates of future cash flows
and discount rates. It is easily applicable to assets and firms when
(a) current cash flows are positive, (b) future cash flows can be
estimated reliably, and (c) the risk profile is stable.

The more removed a situation is from this idealised setting, the

more difficult it is to apply the DCF method. In the following
situations it may be difficult to apply the DCF method or it may be
necessary to make substantial modification to the DCF method:

 Firms which are in distress

 Firms which have highly cyclical operations
 Firms with substantial unutilised assets
 Firms with significant patents and product options
 Firms which are under restructuring
 Firms involved in acquisitions
 Private firms.
 LIMITS OF DCF ANALYSIS
SECURITIES
1. DCF .. STANDARD BONDS
2. DCF .. SENSIBLE … SAFE
STOCKS .. REGULAR DIVIDENDS
3. DCF . . NOT VERY HELPFUL . .
VALUING STOCKS …
SIGNIFICANT GROWTH
OPPORTUNITIES
4. DCF . . NEVER USED FOR
TRADED CALLS
CORPORATE ANALOGS
1. DCF . . VALUE SAFE FLOWS
(LEASES)
2. DCF … CASH COWS, ENGG.
INVEST’TS . . REPLAC’T
3. DCF . . LESS HELPFUL . .
VALUING BUSINESSES
SUBSTANTIAL GROWTH
OPP … OR TANGIBLE ASSETS
4. DCF . . NO HELP … FOR PURE
R & D PROJECTS
 Summary
 There are several models for valuing a company using the DCF approach:
enterprise DCF model, free cash flow to equity model, adjusted present
value model, and economic profit model.
 The enterprise DCF model discounts the free cash flow to firm at the
weighted average cost of capital.
 The free cash flow to equity model discounts the free cash flow to equity
(FCFE) at the levered cost of equity. The FCFE is the cash flow left for
equity shareholders after the firm has provided for its capital
expenditure and working capital needs and met all its obligations
towards lenders and preference shareholders.
 The adjusted present value (APV) model discounts the unlevered equity
cash flow (which is the same as the free cash flow to firm) at the
unlevered cost of equity and adds to it the discounted value of the
interest tax shield on debt.
 The economic profit model discounts the economic profit stream at the
weighted average cost of capital and adds to it the current invested
capital.
THANK YOU