Discounted Cash Flows Methods PDF

Discounted Cash Flows Methods ▷ Discounted cash flow analysis can be done by determining the present value of the net cash flow of the investment opportunity ▷ Cash flow are presented and analyzed based on their sources and activities which are categorized operating, investing...

Discounted Cash Flows Methods ▷ Discounted cash flow analysis can be done by determining the present value of the net cash flow of the investment opportunity ▷ Cash flow are presented and analyzed based on their sources and activities which are categorized operating, investing and financing. Net Cash flows ▷ Refer to the amount of cash available for distribution to both debt and equity claims of the business or assets. ▷ GCBO- Going concern business opportunity - net cash flow generated will be based on the cash flow from operating and investing activities. Net Cash Flows is preferred as basis of valuation if any of the following conditions are present: ▷ Company does not pay dividends ▷ Company pays dividend but the amount paid out significantly differs from its capacity to pay dividends ▷ Net cash flows and profits are aligned within a reasonable forecast period ▷ Investors has a control perspective. ▷ Using net cash flows over other cash flow concepts is more advantageous in a valuation activity since this metric can be directly used as input to a DCF model. ▷ This is not the case for other cash flow or earnings measure such as EBITDA, EBIT, net income and cash flow from operations since these metrics might have missed or double counted an item. Reasons ▷ EBITDA and EBIT are both metrics that are before taxes; cash flows that are available to investors should be after satisfying tax requirements of the government. ▷ EBITDA and EBIT also do not consider differences in capital structures since it does not capture interest payments, dividends for preference shares and funds sourced from bondholders to fund additional investments. ▷ All these measures also do not consider reinvestment of cash flows made into the firm for additional working capital and fixed assets investment that are necessary to maximize long-term stability of the business. Analysts find analyzing cash flows and its sources helpful in understanding the following: ▷ Source of financing for needed investments ▷ Reliance on debt financing ▷ Quality of earnings Two levels of Net Cash flows 1. Net Cash Flow to the Firm Is the amount made available to both debt and equity claims against the company. Cash Flows generated from operating and financing activities of the business which is intended to pay required return of fund provided. Net Cash Flows to the Firm Net Cash Flows to the Firm ▷ It refers to the cash flow available to the parties who supplies capital (i.e. lenders and shareholders) after paying all operating expenses, including taxes, and investing capital expenditures and working capital as required by business needs. Net cash flow to the firm can be computed or derived using approaches A. Based from net Income (or Indirect approach) Net Income Available to Common Php xxx shareholders Add: Non Cash Charges (net) xxx Add: Interest expense (net of Taxes) xxx Add/less: Adjustments in Working Capital xxx Less: Net Investment in Fixed Capital xxx (Purchases-Sales of Fixed Capital Investments Net Cash Flow to the Firm xxx B. From Statement of Cash Flows Cash Flows from Operating activities Php xxx Add: Interest Expense (net of Taxes) xxx Less: Cash Flows from Investing xxx Activities Net Cash Flows to the Firm xxx C. From Earnings Before Interest, Taxes, Depreciation, And Amortization (EBITDA) EBITDA, net of Taxes Php xxx Add: Tax Savings on Noncash Charges xxx Add/Less: Working Capital adjustments xxx Less: Investments in Fixed Capital xxx Net Cash Flows to the Firm xxx Net Cash Flows Equity ▷ Represent the amount of cash flows made available to the equity stockholders after deducting the net debt or the outstanding liabilities to the creditor less available cash balance of the company. ▷ Can be computed from NCFF by considering items related to the lenders and preferred shareholders. Formula: Net Cash Flow to the Firm Php xxx Add: Proceeds from Borrowing xxx Less : Debt Service xxx Add: Proceeds from Preferred Shares xxx Issuance Less: Dividends on Preferred Shares xxx Net Cash Flows to the Equity xxx NCFE can be determine under the following approaches A. Based from Net Income (or Indirect Approach) Net Income Available to Common Shareholders Php xxx Add: Non Cash Charges (net) xxx Add: Interest expenses (net of Taxes) xxx Add/Less: Adjustment in Working Capital xxx Less: Net Investments in Fixed Capital xxx (Purchases – Sales of Fixed Capital Investments) Net Cash Flows to the Firm xxx Add: Proceeds from Borrowing xxx Less: Debt Service xxx Add: Proceeds from preferred shares Issuance xxx Less: Dividends on Preferred Shares xxx Net Cash flows to the Equity xxx B. From statement of Cash flows Cash Flows from Operating Activities Php xxx Add: Interest Expenses (net of Taxes) xxx Less: Cash Flows from Investing Activities xxx Net Cash Flows to the Firm xxx Add: Proceeds from Borrowing xxx Less: Debt Service xxx Add: Proceeds from Preferred Shares Issuance xxx Less: Dividends on Preferred Shares xxx Net Cash Flows to the Equity xxx C. From Earnings Before Interest, taxes, Depreciation and Amortization (EBITDA) EBITDA, net of Taxes Php xxx Add: tax Savings on Noncash Charges xxx Add/Less: Working Capital Adjustments xxx Less: Investments in Fixed Capital xxx Net Cash Flows to the Firm xxx Add: proceeds from Borrowings xxx Less: Debt Service xxx Add: proceeds from Preferred Shares Issuance xxx Less: Dividends on Preferred Shares xxx Net Cash Flows to the Equity xxx Terminal value ▷ is the value of an asset, business, or project beyond the forecasted period when future cash flows can be estimated. ▷ determines a company's value into perpetuity beyond a set forecast period— usually five years. Basis of Terminal Value 1. Liquidity Value 2. Estimated Perpetual Value 𝐶𝐹𝑛+1 𝑇𝑉 = 𝑟−𝑔 TV = Terminal value CFn+1 = farthest net cash flow r = Cost of Capital g = growth rate The Growth rate is computed using Compounded annual growth rate Formula: 1 𝑁𝐶𝐹𝑛 𝑛−1 g= − 1 x 100% 𝑁𝐶𝐹0 NCFn= latest net cash flow NCF0 = net cash flow at the beginning n= Latest Time 3. Constant Growth 4. Scientific Estimates DCF Analysis is most applicable when the following are available ▷ Validated Operational and Financial Information ▷ Reasonable appropriated cost of capital or required rate of return ▷ New quantifiable information Financial Model in Discounted Cash Flow Analysis ▷ A sophisticated and confidential activity in a company or for an analyst. ▷ Information can also be considered as competitive advantage of a company or a person. ▷ Most company hire financial modelers to assist them to validate ballpark estimate and may also opportunities. Financial Modelers have extensive financial judgment and expertise. Normally, they are consists of economists, financial mangers and accountants. Steps in creating Financial Models 1. Gather Historical Information and References 2. Establish Drivers for Growth and Assumptions 3. Determine the Reasonable Cost of Capital 4. Apply the Formulae to compute for the Value 5. Make scenario and sensitivity analysis based on the results Gather Historical Information and References ▷ Historical Information must be made available before the financial model is to be constructed. Historical information may be generated from but not limited to : ○ Audited Financial Statement ○ Corporate Disclosures ○ Contracts ○ Peer Information Historical Information Audited Financial Statements ▷ Used these information to asses the future of the company based on its past performance. ▷ Financial Performance are used to determine historical financial performance ▷ Financial Position are used to determine the book value of the assets and disclosed stakes of the debt and equity financiers ▷ Cash Flows Illustrates how the company historically financing its operations and investments. ▷ Changes in Equity answers the question how much is the claim and dividend background of the company. ▷ Notes to the Financial Statement provides the summary of important disclosures that should be considered in the valuation. Historical Information Corporate Disclosures ▷ Disclosure of future plans and strategies of the company Contracts ▷ Formal agreements between parties. ▷ It is important for the modelers to know the existing contracts and the covenants contained in it. ▷ Due Diligence is necessary to verify any contingent liability and other legal risks surrounding that opportunity and quantify it accordingly to have a more conservative value. Historical Information Peer Information and Other public information ▷ Peers information provides more context and even supports the risk identified or will be assumed in the valuation process. Peers may be other analysts, industry experts and other consultants. ▷ Researches and studies can also be used as peer information. Data that shared through conventions and forums will also be relevant inputs in the development of the financial model and in valuation Gather Historical Information and References ▷ Financial Model must be able to filter the information that would be necessary for the valuation. Relevance and reliability of information are important. Not all information should be given consideration. ▷ Materiality is another consideration. Only relevant item should be considered in the valuation. Establishing Driver for growth and assumptions ▷ Establishing Drivers and assumptions by conducting financial analysis ▷ Drivers are suggested to be those validated and is represented by authorities like government or experts. ▷ Growth Driver ○ Businesses that focuses on producing consumer goods uses population as their growth driver. ○ While service business uses industry growth. ▷ Data Provided by the Government ○ Philippine Statistics Authority ○ Banko Sentral ng Pilipinas ○ National Economic and Development Authority ▷ Philippine Statistics Authority Dashboard Establishing Driver for growth and assumptions ▷ Usual growth indicator used are inflation. Population growth, GNP or GDP growth. ▷ In Economics, Inflation is the result of the movement of prices from a year to another. 𝐶𝑃𝐼𝑛 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = − 1 𝑥 100% 𝐶𝑃𝐼0 𝐶𝑃𝐼𝑛 = 𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑟 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝐶𝑃𝐼0 = 𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑟 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 − 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 Illustration ▷ In 2019, the CPI or the presented A. 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = 155 151 − 1 𝑥 100% cost of the basket is 151. 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = 1.02649 − 1 𝑥 100% 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = 2.65% A. If in the year 2020 the CPI increased into 155, what is the inflation/deflation rate of the year? 149 B. If in the year 2020 the CPI decreased B. 𝐷𝑒𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = 151 − 1 𝑥 100% into 149, what is the inflation/deflation 𝐷𝑒𝑓𝑙𝑎𝑡𝑖𝑜𝑛 =.98675 − 1 𝑥 100% rate of the year? 𝐷𝑒𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = 1.32% Continuation ▷ Using the inflation rate of 2.65% and the communication cost of 5 Million in year 2020, how much will be the cost of communication incorporated in the financial model by the year 2021? 𝐶𝑜𝑚𝑚. 𝐶𝑜𝑠𝑡 = 5,000,000 𝑥 1.0265 𝐶𝑜𝑚𝑚𝑢𝑛𝑖𝑐𝑎𝑡𝑖𝑜𝑛 𝐶𝑜𝑠𝑡 = 5,132,500 Establishing Driver for growth and assumptions ▷ Population Growth Rate- factored in to serve as a growth driver for the demand of the product ▷ The formula of growth rate is similar with the inflation.  Illustration Suppose that in Barangay A in 2021the 26,460 A. 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒 = 25,200 − 1 𝑥 100% population is 25,200. the survey conducted in 𝑔 = 1.05 − 1 𝑥 100% 2022 and the population is 26,460. Assuming 𝑔 = 5% that the estimated consumption of pandesal in barangay A is 5 pieces average per head. Current pandesal sold* 132,300 Increase in pandesal 1.05 What is the growth rate in the year 2022? 138,915 What is the estimated number of pandesal to be sold in 2022 * (26,460 x 5) = 132,300 Determine the reasonable cost of capital ▷ Trend Analysis will also help you establish the trajectory of growth rate. ▷ The financial modeler must assess whether the company can sustain the pattern otherwise it is conservative to assume a less aggressive growth. Determine the reasonable cost of capital ▷ In determining the reasonable cost of capital, the financial modeler must be able to use the appropriate parameters for the company. Generally cost of debt and cost of equity are weighted to determine the cost of capital reasonable for the valuation. Apply the formulae to compute for the value ▷ Normally in Financial Modelling, DCF is used to calculate for the value. Since most information are already available in financial model, it can be easier to use other capital budgeting technique like internal rate of return, profitability Index and Etc. Make scenarios and sensitivity analysis based on the result ▷ The Use of What-If Analysis in creating new scenarios and gathering immediate result of these settings. Component of Financial Model ▷ Financial model should be designed in a way that the investor or the client of the analysts or the proponent themselves can understand the dynamic and follow the drivers to enable them to have a better appreciation and sound judgment of the results. ▷ Financial models are just guide for the investors or even seller of investments to determine the reasonable value. Component of Financial Model ▷ Title Page provides overview and the project being valued or assessed. ▷ Data Key Results summarizes the result of the study ▷ Assumption Sheets summarizes the assumption used in the model ▷ Pro-forma Financial Statements presents the financial statements and key financial ration ▷ Supporting Schedules provides supporting computation to the components of the pro-forma financial statements Fin