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Basics of DCF Valuation
What, How, Whys of DCF
Introduction to Accounting
We discount cash flows.
We, however, have access to accrual-based accounting numbers.
We, therefore, need to know how to convert accrual earnings to cashflow
measures.
We should, therefore, know why:
Depreciation is added back
How capex is computed
What all non-current assets we find in the balance sheet
What adjustments are needed for working capital, and why
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Valuing OLP…
Expected EBIT = Rs. 250 million.
Market Value of Debt (also equal to its book value) = Rs.500 million
What is market value of debt?
When will the market value and book value of debt be equal?
Cost of debt (also equal to the coupon rate) = 10%
Tax rate = 30%
Cost of equity = 20%
Projected growth rate = 0
What are the implications of zero-growth rate?
Capex = Depreciation
Increase in Working Capital = 0
Debt will either not be repaid or refinanced with another equivalent debt
What is its equity value?
What is the enterprise value? (Assume no excess cash with OLP)
Market Value of Debt
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Free Cash Flow and Capital Cash Flow
Free Cash Flow is also known as operating cash flow.
Computed as:
Cashflow to equity + Cashflow to debt – tax shield on interest
EBIT*(1-tax rate) + Depreciation – Capex – Increase in working capital
Capital Cash Flow is computed as:
Cashflow to equity + Cashflow to debt
Also equal to FCF + Interest tax shield
Which is easy to compute?
Why is FCF so popular?
Three Methods of Company Valuation
Value Equity Directly
Discount equity cash flows with cost of equity
Value the company directly
Discount free cash flow at the weighted average cost of capital
Discount capital cash flow at the cost of capital (without tax adjustment in cost of debt)
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Which method is better?
Think of valuing a flat that you have rented. The flat has been partly funded with
mortgage and partly with equity (your own money). How will you value the equity?
Do the same thing while valuing a business.
Exceptions do exist.
Valuing banks/financial institutions
Circularity in Valuation
𝐷 𝐸
𝑊𝐴𝐶𝐶 = 𝐾 1−𝑡 + 𝐾
𝐷+𝐸 𝐷+𝐸
You need to know the enterprise value to estimate the cost of capital.
You need to know the cost of capital to estimate the enterprise value.
𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒 = (assuming zero growth rate)
Do we face circularity while valuing equity directly?
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Dealing with Circularity
Just ignore the problem. (Most people do this!)
Use market-cap and book value of debt to compute the cost of capital. Ignore the
difference between the D+E used to compute the cost of capital and the final D+E that
you obtain as an output.
Assume target D/E while calculating the cost of capital.
Solve the above equation and derive the value of D+E and cost of capital
simultaneously.
Adjusted Present Value Method
Case Study 1: Tata Tea Acquired Tetley in 2001 using its Great Britain subsidiary
(TTGB). Of the total acquisition cost of £271 million, £205 million was funded through
debt.
Case Study 2: Gujarat Government gave a loan of Rs.419.54 crores at 0.1% to Tata
Motors to encourage Tata Motors to set up its Nano factory at Sanand.
Value the company as an unlevered company. Then add the additional benefits of debt
to obtain the levered value.
𝑉 = 𝑉 + 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑
This method is often recommended when debt (or change of it) causes problems.
Let’s value OLP using Adjusted Present Value Method
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Value OLP using APV Method
Expected EBIT = Rs. 250 million.
Market Value of Debt (also equal to its book value) = Rs.500 million
Cost of debt (also equal to the coupon rate) = 10%
Tax rate = 30%
Cost of equity = 20%
Projected growth rate = 0
Capex = Depreciation
Increase in Working Capital = 0
What is its equity value?
What is the enterprise value? (Assume no excess cash with OLP)
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Finding Unlevered Cost of Equity
Can be done in one of the following 3 methods:
𝛽 = 𝛽 × 1 + (1 − 𝑡) × − 𝛽 × (1 − 𝑡) ×
𝐾𝑒 = 𝜌 + 𝜌 − 𝐾𝑑 × × 1 − 𝑡
𝑊𝐴𝐶𝐶 = 𝜌 × 1 − 𝑡 × . Here, we already know WACC.
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Introducing Growth
Let’s assume that OLP will grow at 5% pa.
Let’s also assume that the net investment is Rs. 30 million for the next year.
What is net investment?
Today, we are at the end of year 0. The projected cash flows are expected to come
at the end of year 1.
The debt (as of today) is Rs.500 million.
Kd = 10%
Ke = 20%
Tax Rate = 30%
Expected EBIT (EBIT at the end of one year from today) = Rs.250 million
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How growth gets funded?
A company needs to invest in both fixed assets and working capital to grow.
We are ignoring other assets for the time being.
Some people make a distinction between growth capex and maintenance capex.
While maintenance capex is not needed for growth, growth capex is needed.
Gross Investment: Capex + Increase in Working Capital
Net Investment: Gross Investment – Depreciation
Does it mean depreciation equals maintenance capex?
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Timing of Cashflows
Year 0 Year 1
Debt = Rs.500 Million Projected EBIT = Rs.250 million
Cash = 0 Net Investment = Rs.30 million
All dividends for the last year
already paid.
Growth rate (g) = 5% from here
onwards
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Points to keep in mind
Whenever, we use a constant discount rate (cost of capital or cost of equity), we
assume the DE ratio to remain constant over time.
When a firm grows, constant DE implies the firm increases its debt to keep the DE
constant.
What does it do with this additional money borrowed?
Definition of FCFE
Do not criticize this assumption (constant DE and payment of dividend from
borrowed money) and at the same time use constant discount rate.
If you are not happy with this assumption, change the discount rate each year.
For how long can you do this?
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Implications of Growth
Why a company is assumed to be unlevered in DDM
Meaning of NPV in project finance
Why it is assumed to be distributed as dividends
Why FCF method is preferred to FCFE method
What if debt ratio is not constant?
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Possible Financing Assumptions
Debt (in Rupee value remains constant).
This is the MM assumption.
Debt-Equity ratio remains constant in market value terms.
Debt keeps changing for some time period and then keep the debt ratio (debt to
market value of the company) remains constant.
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What if preference capital is present?
What is preference equity?
No tax shield on preferred dividend.
FCFE computation changes (FCFE is after payment of preferred dividends)
What about FCF?
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Valuation in the presence of Preferred
Equity
Assumptions: Net Income = Rs. 140 million
Growth rate is 0 Preference dividend = Rs. 75 million
Expected EBIT = Rs.250 million FCFE = Rs. 65 million
Debt = Rs.500 million Equity = 65/0.2 = Rs. 325 million
Preference Capital = Rs.500 million Cost of Capital =
Cost of preference Capital = 15% × 0.2 + × 0.15 + × 0.1 ×
Cost of debt = 10% 1 − 0.3 = 13.21%
Cost of equity = 20% Free Cash Flow = Rs.175 million
Tax rate = 30% Enterprise value = 175/0.1321 = Rs.1325
million
Net investment = Rs.0
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An exercise:
Growth Rate = 5% Cost of debt = 10%
Net Investments in year 1 = Rs.30 Cost of equity = 20%
million
Cost of preference capital = 15%
EBIT in year 1 = Rs. 250 million
Tax rate = 30%
Debt (day 0) = Rs.500 million
What is the enterprise value?
Preference capital (day 0) = Rs. 500
million
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