Security Valuation-I

Discounted Cash Flows Techniques

• Zero Growth Stock/Constant Dividend Model
Year 2012 2013 2014 2015 2016
Dividend 2 1.75 1.7 2 2

Growth rate(g):
FV = P( 1+i)n
2 =2 (1+g)4
g=0
Cost of equity (Ke) = 10%
Condition for constant growth model:
Ke ˃ g

Ke =10% ˃ g= 0%, condition is being met, so we can go for

constant growth model to find out intrinsic value of stock
V = Do (1 + g)
Ke - g
V = 2(1+0)
0.10- 0
V = Rs.20= This is the intrinsic value of stock, and this will have to be
compared with the prevailing MPS to find out, either stock is under-
priced or over-priced
Phased Growth Model/Super Normal Growth
Model
Q. Current Dividend paid = Rs.2
Following expected growth rates
Year Expected Dividend Growth Rate
1–3 25%
4–6 20%
7–9 15%
10 on 9%
Required rate of return = 14%
Required : Compute the intrinsic value of stock of the firm
Phased Growth Model
Year Dividend Discount Factor@ 14% Present Value
1 2.5 0.8772 2.193
2 3.12 0.7695 2.401
3 3.91 0.6750 2.639
4 4.69 0.5921 2.777
5 5.63 0.5194 2.924
6 6.76 0.4556 3.080
7 7.77 0.3996 3.105
8 8.94 0.3506 3.134
9 10.28 0.3075 3.161
Total 25.414
Phased Growth Model
For 10th year and on wards:

V = Do (1 + g)
Ke - g
Value of stock at the end of year 9 = 10.28(1.09)/(0.14-0.09)
= 224.104
Present value of stock’s value = 224.104 * 0.3075
= 68.912
Present value of all future cash flows = 25.41 + 68.91
=Rs.94.32 = This is the intrinsic value of stock
Free Cash Flows(FCF) Approach
• FCF is the amount of cash flows remaining after a company makes the
asset investments necessary to support the business operations(capital
expenditure needs & working capital needs).In other words, FCF is the
amount of cash flow available for distribution to the investors/capital
providers/resource providers, which include shareholders and
debtholders.
• FCF are attributed to debt and equity providers or on free cash flows,
right of debt and equity providers exist.
• So the discount rate for free cash flows will be WACC
Free Cash Flows(FCF) Approach
• Uses of Free Cash Flows (FCF):
1) Company can make interest payments out of the free cash flows
2) Company can make repayment of principal amount of loan/debt out
of the free cash flows
3) Company can make dividend payments out of the free cash flows
4) Company can buy back the shares out of the free cash flows
5) Company can make short term investments out of the free cash
flows
Free Cash Flows(FCF) Approach
FCF defined:

FCF = EBIT(1-tax) + Dep Exp – CAPEX  change in Working

Capital

CAPEX = Capital Expenditures

W.C = Current Assets – Current Liabilities
Free Cash Flows(FCF) Approach
Q. year 1 2 3 4 5

EBIT 2000 2200 2500 3000 3500

Depreciation 300 300 300 500 500
Capital Exp. 400 400 400 400 400

Working Capital = 10% of EBIT

Debt/Equity = 40 : 60
Kd = 12% Ke = 20% Tax rate= 20%
Assume Cash Flows are constant after five years.
Debt = Rs.4000 No of shares O.S= 1000
Free Cash Flows(FCF) Approach
• Required:
a) Compute fair value of the firm
b) Compute value of equity of the firm
c) Compute fair value per share of the firm
d) If current MPS of the stock of firm is Rs.20, state also whether the
stock of firm is under/over priced
Free Cash Flows(FCF) Approach
Year 1 2 3 4 5
EBIT 2000 2200 2500 3000 3500

Tax (20%) (400) (440) (500) (600) (700)

EBIT(1 – tax) 1600 1760 2000 2400 2800

Dep Exp 300 300 300 500 500

EBIT(1 – tax) 1900 2060 2300 2900 3300
+ Dep Exp

CAPEX (400) (400) (400) (400) (400)

1500 1660 1900 2500 2900

() W.C 0 (20) (30) (50) (50)

FCF 1500 1640 1870 2450 2850
• Working capital computation:

Year 1 EBIT = 2,000

Year 2 EBIT = 2,200
Change = 200
Working capital = 10% of EBIT
= 10% of 200
= 20
Free Cash Flows(FCF) Approach
Weightage Cost Weight x Cost

Equity 60 Ke = 20% 0.20 x 0.6 = 0.12

Debt 40 Kd = 12% 0.096 x 0.4 = 0.0384

Kd(1-T) =0.12(1-0.2)
= 0.096

WACC = 0.1584
Free Cash Flows(FCF) Approach
Discounting of FCF
DCF 1/1.1584 1/(1.1584)2 1/(1.1584)3 1/(1.1584)4 1/(1.1584)5

PV of FCF 1500/1.1584 1640/(1.1584)2 1870/(1.1584)3 2450/(1.1584)4 2850/(1.1584)5

=1294 =1222 =1203 =1360 =1366

PV of FCF for 1 – 5 years = 1294+1222+1203+1360+1366

= 6445
Free Cash Flows(FCF) Approach
Perpetual/Perpetuity
Cash flow for 6th year and onwards is as;
Perpetuity = CF/I
= FCF/WACC
= 2850/0.1584
Terminal value = 17992.4
PV of CF of 6th year
= 17992.4/(1.1584)5
= 8625
Free Cash Flows(FCF) Approach
a) Value of company/ firm = 8625 + 6445
= 15070
b) Value of equity of the firm = 15070 – 4000
= 11070
c) fair/ market Price of Share = 11070/1000
= Rs. 11.07/share
Current Price of share = Rs 20
Decision?
Stock of the firm is over-Priced
Practice Question FCF Approach
• Q. year 2008 2009 2010 2011 2012
EBIT 3,000 3,500 3,700 4,200 4,500
Depreciation 500 500 600 600 700

Capital Exp. 600 600 700 750 700

Working Capital = 10% of EBIT

Debt/Equity = 40 : 60
Kd = 15% Ke = 20% Tax rate= 30%
Assume Cash Flows will grow at a constant rate after year 2012.
Debt = Rs.30,000 No of shares O/S= 1000
• Required:
a) Compute fair value of the firm
b) Compute value of equity of the firm
c) Compute fair value per share of the firm
d) If current MPS of the stock of firm is Rs.30, state also whether the
stock of firm is under/over priced
Note: In this case, as cash flows are growing at a constant rate, so
growth rate has to be found to be used in the constant growth model
formula for the computation of terminal value
Free Cash Flows to Equity (Residual Equity Approach)

• This cash flow is attributable only to the equity providers

• So the discount rate for the cash flows will be Ke

• RECF = Net Income(Earning after taxes) + Dep Exp – CAPEX 

change in Working Capital  change in loan
Practice Question RECF Approach
Q. year 2008 2009 2010 2011 2012
NI 2,000 2,300 2,200 2,700 2,900
Depreciation 500 500 600 600 700
Capital Exp. 600 600 700 750 700
() Loan (30) 40 50 (20) 30

Working Capital = 10% of EBIT

Ke = 20%
Assume Cash Flows will grow at a constant rate after year 2012.
No of shares O/S= 1000
Free Cash Flows to Equity (Residual Equity Approach)

• Required:
a) Compute value of equity of the firm
b) Compute fair value per share of the firm
c) If current MPS of the stock of firm is Rs.35, state also whether the
stock of firm is under/over priced
Practice Question FCF Approach
• Q. The balance sheet of Fatima Fertilizer Limited at the end of previous year is as follows:
Rs. in million
Liabilities Assets
Shareholder’s funds: Net fixed assets 550
Equity capital (20 million
Shares of Rs.10 each) 200
Retained earnings 300
10% loan 250 Net working capital 200

750 750
• Additional Information:
• Net operating profit after tax (NOPAT) is expected to be 18 % of the
asset value as at the beginning of each year. The growth rate in assets
and revenues will be 30% for the first three years,18% for the next two
years and 10 % thereafter. The effective tax rate of the firm is 34 %,
the pre-tax cost of debt is 10 % and the cost of equity is 24 %.The
debt-equity ratio of the firm will be maintained at 1:2.
• Required:
a) Forecast the free cash flows (FCF) of the company using the following table:
Rs.in million
Year 1 2 3 4 5 6
• Asset value (Beginning)
• NOPAT
• Net investment
• FCF
• Growth rate (%)
b) Calculate horizon value and enterprise value of the firm
Solution

• a) Forecasting of Free cash Flows (FCF):

Year 1 2 3 4 5 6
Asset 750 975 1267.5 1647.75 1944.35 2294.33
value(Beginning)
NOPAT 135 175.5 228.15 296.60 349.98 412.98
Net investment 225 292.5 380.25 296.6 349.98 229.43
FCF (90) (117) (152.10) 0 0 183.55
Growth rate (%) 30 30 30 18 18 10
• Year 7 Asset Value = 2294.33 * 1.10 = 2523.76
• Net Investment in Year 6 = 2523.76 – 2294.33 = 229.43
• Weighted average cost of capital (WACC):
• WACC = (2/3) * 24% + (1/3) * 10% (1- 0.34)
• WACC = 18.2 %
• b) Horizon value of the firm:
• Horizon value =
• Horizon value =
• Horizon value = Rs. 2462.26 million
• b) Enterprise value of the firm:
• EV = + + + + + +
• EV = (76.14) + (83.74) + (92.10) + 0 + 0 + 67.31 + 902.89
• EV = Rs. 718.22 million