NET CASH FLOWS AND FINANCIAL
MODELS IN Discounted Cash
Flow ANALYSIS
Learning Objectives
1. Discuss the discounted cash flow method.
2. Compute the net cash flow to the firm.
3. Compute the net cash flow to equity.
4. Compute the terminal value.
5. Discuss the steps in financial models.
6. Understand the components of financial models.
Discounted Cash Flow
Analysis
DISCOUNTED CASH Flow
Discounted cash flow (DCF) is a valuation method
used to estimate the value of an investment based on
its expected future cash flows. DCF analysis
attempts to figure out the value of an investment
today, based on projections of how much money it
will generate in the future.
DISCOUNTED CASH Flow (dcf)
formula
DCF = [CF1/(1+r)^1] + [CF2/(1+r)^2] + [CF3/(1+r)^3] +... + [CFfortheyear/(1+r)^n]
WHERE: CF = The cash flow for the given year.
CF1is for year one, CF2is for year two, CFn is for additional years.
r = The discount rate.
When a company analyzes whether it should invest in a certain project or
purchase new equipment, it usually uses its weighted average cost of capital
(WACC) as the discount rate when evaluating the DCF. The WACC
incorporates the average rate of return that shareholders in the firm are
expecting for the given year.
For example, say you are looking to invest in a project, and your company’s
WACC is 5%, meaning you will use 5% as your discount rate. The initial
investment is P11 million, and the project will last for five years, with the
following estimated cash flows per year:
DISCOUNTED CASH Flow (dcf)
formula
DCF = [CF1/(1+r)^1] + [CF2/(1+r)^2] + [CF3/(1+r)^3] +... + [CFfortheyear/(1+r)^n]
= [1,000,000/(1+0.05)^1] + [1,000,000/(1+0.05)^2] +
[4,000,000/(1+0.05)^3] + [4,000,000/(1+0.05)^4] +
[6,000,000/(1+0.05)^5]
Therefore, the discounted cash flows for the project are:
(nearest ₱)
Net Present Value = Initial Investment - Total Discounted Cash Flows
= P11 million - P13,306,727
= P2,306,727
Net Cash Flow
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
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
Investor has a control perspective.
Net cash flows are preferred in valuation activities because they
can be directly used in a DCF model, unlike other metrics like
EBITDA, EBIT, net income, or cash flow from operations, which may
overlook or double-count certain items.
EBITDA and EBIT are both metrics that are before taxes.
EBITDA and EBIT also do not consider differences in capital structures.
All these measures also do not consider reinvestment of cash flows made
into the firm.
In valuation, analyst find analyzing cash flow
and its sources helpful in understanding the
following:
Sources of financing for needed investment
Reliance on debt financing
Quality of earnings
Two levels of Net Cash Flow:
1.Net cash flow to the firm
2.Net cash flow to the Equity
Net Cash Flow TO THE FIRM
refers to the cash flow available to the parties
who supplied capital (i.e. lenders and
shareholders) after paying all operating
expenses, including taxes, and investing in
capital expenditures and working capital as
required by business needs.
APPROACHES IN COMPUTING NET CASH FLOW TO THE FIRM
From
statement of
cash flow
Net Cash
Based from
Net Income Flow From EBITDA
to the Firm
A. Based from Net Income (or indirect approach)
Example
Example 11
Example 1
After-tax Interest Expense = 17.25 × (1 - 0.30) = 12.08
Invesment in Fixed Capital = 550 - 500 = 50
Adjustment in Working Capital
Changes in Accounts Receivable = 110 - 100 = 10
Changes in Inventory = 72.6 - 66 = 6.6
Changes in Accounts Payables = 55 - 50 = 5
= 10 + 6.6 - 5 = 11.6
B. From Statement of Cash Flow
Example 2
Example 2
C. From Earnings Before Interest, Taxes,
Depreciation and Amortization (EBITDA)
Example 3
Singapore Ltd., has reported PHP 125,000 revenue where
their EBITDA Margin is 45%.If the taxes are 30% of the
EBITDA and the capital expenditure was purchased at
PHP1,500, how much is the Net Cash Flow?
Example 3
EBITDA = 125,000 x 45% x ( 1-.30)
= 39,375
NCFF = 39,375 - 1,500
NCFF = 37,875
Net Cash Flow to Equity
(NCFE)
Net Cash Flow to Equity
Refers to the cash available for common equity
participants or shareholders only after paying
operating expenses, satisfying operating and
fixed capital requirements, and settling cash flow
transactions involving debt providers and
preferred shareholders.
Net Cash Flow to Equity
NCFE can be computed from NCFF by
considering items related to lenders and
preferred shareholders. NFCE signifies the level
of available cash that a business can freely
declare as dividends to its common
shareholders.
Net Cash Flow to Equity
Net Cash Flow to Equity
Proceeds from Borrowing
Debt Service
Proceeds from Issuance of Preferred Shares
Dividends on Preferred Shares
APPROACHES IN COMPUTING NET CASH FLOW TO EQUITY
BASED FROM NET
INCOME
NET CASH FLOW
TO EQUITY
BASED FROM
BASED FROM
STATEMENT OF
EBITDA
CASH FLOWS
A. Based from Net Income (or indirect approach)
A. Based from Net Income (or indirect approach)
100M ×( 1−0.40)= 60M
2.6B - 2.2B = 400M
100M × (1−40%) = 60M
Adjustment in Working Capital
Increase in Accounts Receivable = ₱600M - ₱560M = ₱40M Proceeds from borrowing
Increase in Inventory = ₱440M - ₱410M = ₱30M NOTES PAYABLE 250M - 200M = 50M
Increase in Accounts Payables = ₱300M - ₱285M = ₱15M LONG TERM DEBT 890M - 865M = 25M
Increse in Accrued Taxes and Expenses= ₱150M - ₱140M = ₱10M = 75M PROCEEDS FROM BORROWINGS
= 70M CA - 25M CL = 45M Investment in Working Capital
B. From Statement of Cash Flow
B. From Statement of Cash Flow
=100M (1-Tax rate) = 100M (1-0.40) = 60M
=2.2B - 2.6B
100M × (1−40%) = 60M
Adjustment in Working Capital Proceeds from borrowing
Increase in Accounts Receivable = ₱600M - ₱560M = ₱40M NOTES PAYABLE 250M - 200M = 50M
Increase in Inventory = ₱440M - ₱410M = ₱30M LONG TERM DEBT 890M - 865M = 25M
Increase in Accounts Payables = ₱300M - ₱285M = ₱15M = 75M PROCEEDS FROM BORROWINGS
Increse in Accrued Taxes and Expenses= ₱150M - ₱140M = ₱10M
= 70M CA - 25M CL = 45M Investment in Working Capital
C. From Earnings Before Interest, Taxes,
Depreciation and Amortization (EBITDA)
C. From Earnings Before Interest, Taxes,
Depreciation and Amortization (EBITDA)
= 800M (1-Tax rate) = 800M (1-0.40) = 480M
= 300M x 40%
TERMINAL VALUE
Represents the value of the company in perpetuity
or in a going concern environment.
BASIS OF TERMINAL VALUE
1.Liquidation Value
2.Estimated Perpetual Value
3.Constant Growth
4.Scientific Estimates
BASIS OF TERMINAL VALUE
Liquidation Value
Some analysts find that the terminal
value be based on the estimated
salvage value of the assets.
BASIS OF TERMINAL VALUE
Estimated Perpetual Value
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.
For example, a Filipino company is expecting for
15% returns for a venture and assumes that their
net cash flows for the next 5 years are as follows:
YEAR NET CASH FLOWS
1 5,000,000
2 5,500,000
3 6,050,000
4 6,660,000
5 7,320,000
Assuming that the cash flow will
continuously grow at the rate of 10%
per annum, what will be the terminal
value of Filipino company?
BASIS OF TERMINAL VALUE
3. Constant Growth
Challenges for some valuators is to determine the
amount of required return for a specific type of
asset or investment.
BASIS OF TERMINAL VALUE
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.
