Corporate Finance: DCF Methods

Corporate & Entrepreneurial Finance: Firm Valuation - DCF Methods

• Module Objectives: Refresh knowledge of Discounted Cash Flow (DCF) methodology, learn to apply DCF to collect input data for public and privately held companies.

• Agenda: Discounted Cash Flow Methods and a Brenntag DCF Case study.

Entity vs. Equity Approach

• Entity Approach (using WACC):

  • Step 1: Calculate the Enterprise Value (EV) of the company, using assets as a starting point.
  • Free Cash Flows (FCF): Project "Entity- Free Cash Flows" considering adjustments for taxes, assuming a fully equity-financed company.
  • WACC Discounting: Discount FCFs using the Weighted Average Cost of Capital (WACC) considering the company's capital structure (debt and equity) and tax shield.
  • Step 2: Calculate Equity Value by deducting net debt from the EV.

• Equity Approach:

  • Direct Calculation: Forecast "Equity Free Cash Flows" considering actual capital structure and adjusting for interest payments.
  • Discount with Cost of Equity: Discount Equity FCF using the firm's cost of equity.
  • Application: Typically applied for financial institutions (banks, insurance companies) when valuing stocks.

Entity DCF Method

• Cash Flow Diagram: Shareholders receive cash for distributions, the company pays interest, and debt holders receive payments.
• Tax Adjustments: Free Cash Flows are adjusted for taxes.
• WACC Discounting: Free Cash Flows are discounted using WACC.
• Enterprise Value Calculation: Enterprise value is calculated.
• Equity Value Calculation: Equity value is calculated by subtracting net debt from the enterprise value.

Entity Approach DCF-Method - Two Stages Model

• Enterprise Value (Asset Value): The total value of the company.
• Net Debt: The total debt of the company.
• Equity Value: The value of the equity of the company which is calculated by subtracting the net debt from the enterprise value.
• Discounting Free Cash Flows: Free cash flows are discounted based on the WACC.
• Terminal Value: The value of future cash flows after the explicit projection period.

Calculation of (Entity-) Free Cash Flows

• NOPLAT (Net Operating Profit Less Adjusted Taxes): A key financial metric representing a firm's operating profit after adjusting for taxes, calculated as EBIT multiplied by (1 - tax rate).
• Depreciation: Non-cash expense reflecting the decline in asset value over time.
• Increase/Decrease of Long Term Provisions: Adjustments related to long-term provisions.
• Increase/Decrease of Net Working Capital: Changes in current assets and liabilities.
• Capital Expenditure/Divestments: Outlays for capital assets and proceeds from selling capital assets.
• Free Cash Flow: The ultimate result, the cash available to the company's investors

Discount Rate - Applied for the Entity DCF Method

• WACC (Weighted Average Cost of Capital): The weighted average of the cost of equity, and debt given the market value of equity and the market value of debt.
• Equity Ratio: Represents the proportion of equity to total capital.
• Debt Ratio: The proportion of debt to total capital.
• Cost of Equity: Cost of equity funding the firm.
• Cost of Debt: Cost of debt funding the firm.
• Corporate Tax Rate: Percentage of profits paid as corporate tax.

Practical Solutions to the Circularity Problem

• Use the Market Cap: Market capitalization as a proxy for equity market value (for listed firms only).
• Calculate Equity/Debt Ratios: Based on a target capital structure.
• Use an Iterative Approach: An iterative approach for finding a solution that better fits.

Cost of Equity Calculation based on CAPM

• The Capital Asset Pricing Model (CAPM) estimates cost of equity based on systematic risk.
• RF (Risk-Free Rate): The rate of return on a risk-free investment.
• BETA (Equity (Geared) Beta-faktor): Measures the volatility of a stock relative to the market.
• rm-rf (Expected Market Risk Premium): The difference between the expected market return and the risk free return.
• Security Market Line: Depicts the relationship between risk and return using the CAPM for each security

Unlevering and Relevering of Betas

• Leverage impacts a firm's beta.
• Levered Beta (βL): The beta of a company with debt.
• Unlevered Beta (βU): Beta of a company without debt.
• Tax Shield: The reduction in taxes due to debt.

Unlevering and Relevering Beta - Example

• Comparable Companies: Similar firms used for analysis.
• Capital Structure: Debt-to-Equity ratios in those companies.
• Unlevering: Adjusting the betas of comparable firms to remove the impact of debt, calculating the unlevered beta (βu).

Projecting the Terminal Value

• Projection of Period Perpetuity Growth CF: Based on the final projected cash flow.
• Value Driver Formula: Allows calculation of a Free Cash Flow that takes into account long-term average Capex assumptions.
• Terminal Value: Value of cash flows projecting beyond the explicit period.

Exercise 1: DCF Valuation of Eau de Cologne

• Financial Projections: Detailed financial forecasts are given for the firm.
• Valuation Model: Determine the enterprise value (EV) of Eau de Cologne.
• Compare Capital Structure: Analyse the implications of the capital structure on the results.
• Recalculate DCF Value: Recalculate value using different parameters

Exercise 2: Questions on Free Cash Flow Calculation

• Adjusted Taxes: In the context of free cash flow calculation, are lower than actual taxes payable by the firm.
• Inventory Increase: An increase in inventory (compared to previous year) implies a higher free cash flow.
• Trade Payables Increase: An increase in trade payables implies a higher free cash flow.
• Interest Expense: Lower interest expense leads to higher free cash flow.

Generating the Data to Arrive at Meaningful FCF Forecasts

• Data Gathering: Collect accurate and consistent data for meaningful forecasts
• Meaningful Projections: Develop forecasts that can be well understood.

How to Estimate the WACC

• Accurate Data Sourcing: Address problems encountered when sourcing the data used in the WACC calculation.

Case Study: DCF-Valuation Brenntag AG (pre-IPO)

• Data Requirements: The analyst would need to replicate existing projections by filling missing dat in an Excel template.
• WACC Assumptions: Model Weighted Average Cost of Capital based on the provided assumptions.
• DCF Equity Value: Model the firm's DCF.
• External Inputs: Use empirical data (from the relevant website) and an industry average beta.
• Valuation Matrix: Adjust for terminal growth rate and WACC.