Corporate Finance: DCF Methods

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Questions and Answers

Which of the following statements regarding the calculation of free cash flows in the context of the Entity Discounted Cash Flow method is true/false?

  • An increase in trade payables compared to the previous year implies, ceteris paribus (all other things equal), a higher free cash flow in the current year. (correct)
  • An increase in inventory compared to the previous year implies, ceteris paribus (all other things equal), a higher free cash flow in the current year.
  • Adjusted taxes, in the context of the free cash flow calculation, are lower than actual taxes payable by the firm. (correct)
  • The lower the interest expense, the higher ceteris paribus (all other things equal) the firm's free cash flow.

What are the two approaches of the DCF method and what is the standard approach?

The two approaches of the DCF method are the Entity Approach and the Equity Approach. The standard approach is the Entity Approach.

What is the standard approach when valuing companies across different sectors/industries when using the DCF method and why? (Select all that apply)

  • The standard approach is the Entity Approach because it focuses on the company's overall operations. (correct)
  • The standard approach is the Equity Approach because it's more straightforward to calculate equity value than enterprise value.
  • The standard approach is the Equity Approach because it provides a more accurate valuation of the company’s equity.
  • The standard approach is the Entity Approach because it considers the company's debt structure. (correct)

What is the difference between the Entity Approach and the Equity Approach in the context of DCF?

<p>The Entity Approach focuses on the company's overall value, considering both equity and debt, while the Equity Approach solely focuses on the value of equity.</p> Signup and view all the answers

What is the definition of Free Cash Flow used in the Entity Approach of DCF?

<p>Free Cash Flow in the Entity Approach refers to the cash flow available to both equity and debt holders after deducting taxes and necessary investments.</p> Signup and view all the answers

What is the main difference between the free cash flow definition used in the Entity Approach and the Equity Approach?

<p>The Entity Approach's free cash flow considers all cash flow available to both debt and equity holders, while the Equity Approach's free cash flow considers only cash flow available to equity holders.</p> Signup and view all the answers

In the Entity Approach, the free cash flow is discounted using the ______

<p>weighted average cost of capital (WACC)</p> Signup and view all the answers

What is the purpose of the terminal value in the DCF model?

<p>The terminal value represents the present value of all future cash flows beyond the explicit forecast period.</p> Signup and view all the answers

What are the two main methods for estimating the terminal value in a DCF model?

<p>Perpetuity Growth Model and Value Driver Formula (A)</p> Signup and view all the answers

What are some of the common challenges or issues faced when estimating the WACC?

<p>Common challenges include determining the appropriate cost of equity, debt, and the company's target capital structure.</p> Signup and view all the answers

What are some common methods to address circularity in the DCF model?

<p>Common methods include using market cap as a proxy for equity value, assuming a target capital structure, and iteratively solving for the WACC.</p> Signup and view all the answers

What is the purpose of unlevering and relevering betas in valuation?

<p>Unlevering and relevering betas are used to adjust the beta of a company for its capital structure, allowing comparisons with other companies with different debt-to-equity ratios.</p> Signup and view all the answers

Why is it considered a challenge to estimate the WACC in the DCF method?

<p>Estimating the WACC is a challenge because it involves determining the appropriate costs of equity and debt, as well as accurately predicting future capital structure.</p> Signup and view all the answers

The terminal value in a DCF analysis represents the present value of all future cash flows beyond the explicit forecast period.

<p>True (A)</p> Signup and view all the answers

What are the two main components of the WACC?

<p>The two main components of the WACC are the cost of equity and the cost of debt.</p> Signup and view all the answers

Flashcards

Discounted Cash Flow (DCF) Method

A valuation method that discounts future free cash flows to their present value using a discount rate, such as the Weighted Average Cost of Capital (WACC).

Free Cash Flows (FCF)

Cash flows available to distribute to all investors (shareholders and debtholders) after accounting for taxes, interest payments, and necessary investments.

Weighted Average Cost of Capital (WACC)

The discount rate used in the DCF method to reflect the riskiness of future cash flows.

Enterprise Value (EV)

The value of a company's assets, including both debt and equity.

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Equity Value

The value of a company's equity, representing the ownership stake held by shareholders.

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Entity Approach

A DCF method that calculates the Enterprise Value first, then subtracts Net Debt to arrive at Equity Value.

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Equity Approach

A DCF method that directly calculates Equity Value by discounting “Equity Free Cash Flows” with the Cost of Equity.

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Cost of Equity (rE)

The rate of return required by investors on a company's equity, taking into account its risk.

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Cost of Debt (rD)

The rate of return required by investors on a company's debt, taking into account its risk.

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Debt-to-Equity Ratio (D/E)

The ratio of a company's market value debt to its market value equity.

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Beta Factor (β)

A measure of a company's risk compared to the overall market, used to calculate the Cost of Equity.

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Unlevering and Relevering Betas

A process of adjusting a company's Beta factor to reflect its capital structure.

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Terminal Value

The value of a company's cash flows beyond the explicit projection period, assumed to grow at a constant rate.

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Value Driver Formula

A model that uses long-term average Capex assumptions aligned with growth expectations to estimate the Terminal Value.

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Return on Invested Capital (ROIC)

The return on invested capital (ROIC) is a profitability ratio that measures how effectively a company uses the money invested in its operations.

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Plausibility Checks

The process of verifying and adjusting financial projections to ensure their plausibility and consistency.

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Top-Down Approach

An approach to financial forecasting that starts with overall market trends and works down to specific company projections.

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Bottom-Up Approach

An approach to financial forecasting that starts with individual company operations and builds up to overall projections.

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COGS Margin

The cost of goods sold (COGS) margin measures the profitability of a company's core business operations.

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SG&A Expenses

A component of operating expenses that includes administrative spending.

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Net Working Capital (NWC)

The difference between the current assets that are required to generate revenue and the current liabilities that are coming due in the near term (within a year, say).

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Balance Sheet

A financial statement that presents the company's assets, liabilities, and equity at a specific point in time.

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Capital Expenditures (Capex)

Spending on tangible assets, including property, plant, and equipment (PP&E).

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Yield to Maturity (YTM)

The Yield to Maturity (YTM) is the total return anticipated on a bond if it is held until the maturity date.

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Long-Term Government Bonds

Government bonds with a maturity of 10 years or longer.

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Svensson Method

A method used to adjust observed bond yields to reflect the yields of zero-coupon bonds.

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Bloomberg

A source of financial data, often used for research and analysis.

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Reuters

A source of financial data, used for research, analysis, and trading.

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Regression Analysis

A method of estimating the expected return on a stock by examining its historical price movements.

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Damodaran Industry Betas

A database containing financial data and research on various companies and industries.

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Market Risk Premium

The difference between the expected return on the market and the risk-free rate.

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Security Market Line (SML)

A tool used to display the relationship between the expected return of an investment and its systematic risk (Beta).

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Interest Expense

The interest expense incurred by a company on its debt financing.

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Iterative Approach

An iterative approach used to solve for a value when there is a circular dependency between variables.

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Initial Public Offering (IPO)

An initial public offering (IPO) is the process of offering shares of a private company to the public for the first time.

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Syndicate Bank

A syndicate bank is a group of banks that work together to underwrite and distribute securities.

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Valuation Matrix

A valuation matrix is a table summarizing the results of multiple valuations based on different assumptions.

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Study Notes

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.

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