Discounted Cash Flows

Compare money flows occurred at different points of time

By compounding: converting earlier money to a later value
By discounting: converting later money to an early value
t=0

Present value (PV)

T-1

Future value (FV)

Future value of investment CF0 over T periods: FV = CF0 1 + R

Present value of future cash flow in T periods CFT : PV =

CFT
1+R T

DCF Valuation 1

Discounted Cash Flows

The effect of inflation
Let RReal be the real interest rate, and i be the inflation rate.
The relation between the nominal interest rate, R, and the real

interest rate is: 1 + R = 1 + R Real 1 + i

The nominal future cash flow, CFt , and its inflation-adjusted (IA)

cash flow is related as: CFt = CFtIA 1 + i

Therefore,

PV =

CFt
1+R t

CFIA
t
1+RReal t

Therefore, nominal cash flows must be discounted at the nominal

rate, or real cash flows must be discounted at the real rate.

DCF Valuation 2

Discounted Cash Flows

Present value of an annuity
An annuity is a finite series of equal payments that occur at regular
intervals.

Date:

Cash flow:
PV

T+1

T+2

C
C
C
C
1

2
T
T

1 R (1 R)
R 1 R
(1 R)

Example: If you can afford a $400 monthly car payment, how much car
can you afford if interest rates are 7% on 36-month loans?

PV

$400
1
1

$12,954.59

36
0.07/12 (1 0 .07 12)
DCF Valuation 3

Discounted Cash Flows

Present value of a growing annuity
A growing annuity is a growing (at a constant rate) stream of cash flows
with a fixed maturity

Date:
Cash flow:

1
C

C(1+g) C(1+g)2

T+1

T+2

C(1+g)T-1

C
C1 g
C1 g T 1
C
1 g T
PV

1
1 R (1 R)2
R g
(1 R)T
1 R T
Example: A retirement plan offers to pay $20,000 per year for 40 years
and increase the annual payment by three-percent each year. What is the
present value at retirement if the discount rate is 10%?

$20,000 1.03
PV
1

0.10 0.03 1.10

40

$265,121.57

DCF Valuation 4

Discounted Cash Flows

Present value of a growing perpetuity
A growing perpetuity is a growing (at a constant rate) stream of cash
flows that lasts forever.

Date:

Cash flow:

PV

1
C

C(1+g) C(1+g)2

C
C1 g
C

(1 R)
R g
(1 R)2

where R g

Example: The expected dividend next year is $1.30 and dividends are
expected to grow at 5% forever. If the discount rate is 10%, what is the
value of this promised dividend stream?

PV

1.30
$26.00
0.10 0.05
DCF Valuation 5

Net Present Value (NPV)

Concept
Example: A factory costs $400,000. You forecast that it will produce cash
inflows of $120,000 in year 1, $180,000 in year 2, and $300,000 in year
3. The discount rate is 12 percent. Is the factory a good investment?
We need to compare the cost and the benefit of the investment. To do so,
we convert all cash flows to time 0 (or to any time point).

PVcost $400,000
PVbenefit

$120,000 $180,000 $300,000

$464,171.83
1.12
1.12 2
1.123

The present value of all cash inflows, $464,172, is more than the present
value of cash outflow, $400,000. The factory is a good investment.
The net (economic) benefit $64,172 is the NPV of this investment.
DCF Valuation 6

Net Present Value (NPV)

The NPV investment decision rule
C1
C2
CT
NPV C0

2
1 R (1 R)
(1 R) T
The first term is usually the initial cash outflow, so its negative.

The remaining terms together are the present value of all future

cash flows.
Decision rule: accept the project if NPV > 0

DCF Valuation 7

Internal Rate of Return (IRR)

Concept
A projects IRR is such a discount rate that makes the NPV = 0.

Hence, given the cash flows, the IRR is determined by solving the
following equation:

0 C0

C1
C2
CT

...

(1 IRR)1 (1 IRR) 2
(1 IRR)T

(0 NPV)

The calculation becomes simple by using a financial calculator or

spreadsheet.

Decision rule: accept the project if IRR > Required return

The required return is called the hurdle rate.

DCF and Bond and Stock Valuation 8

Internal Rate of Return (IRR)

Calculation of IRR
Example: You can purchase a building for $350,000. The investment
will generate $16,000 in cash flows (i.e. rent) during the first three
years. At the end of three years you will sell the building for
$450,000. What is the IRR on this investment?

0 350,000

16,000
16,000
466,000

(1 IRR )1 (1 IRR ) 2 (1 IRR ) 3

Calculating the IRR using spreadsheet or by try and error: Start

with a guessed number for IRR, test it, guess again ... until your
guess is sufficiently close to the real IRR:
IRR = 12.96%

DCF and Bond and Stock Valuation 9

Valuing Bonds
The present value of a bond
As for any investment, we need to estimate the future cash flows from a
bond: size (how much) and timing (when)
A bond has a maturity (of cash flows).
Discount bond cash flows at an appropriate interest rate (that is consistent with
the risk presented by the bond)

A bond obligates the issuer to make specified payments to bondholders

Par value (or face value): The principal amount of a bond that is repaid at the
end of the term.
Coupon: The bondholder receives an interest payment each period until the
bond matures, which are coupon payments (determined as a percentage of face
value, which is the coupon rate.)
Maturity: The specified date on which the principal amount is paid.
Price: The amount the bondholder pay today to acquire the bond.
DCF Valuation 10

Valuing Bonds
A level-coupon bond
Date:

Cash flow:

PV

T-1

$C

$C

$C

$C+F

C
1
F
1

R (1 R) T
(1 R) T

F: face value
C: coupon payment, as a percentage (coupon rate) of face value
T: time to maturity (number of coupon payments)
R: discount rate

DCF Valuation 11

Valuing Bonds
Yield to maturity of a bond
In the formula for the present value of bonds, the discount rate R is

the bonds yield to maturity (YTM). That is, YTM is the discount
rate at which the bonds present value equals the price.
Bond Price

C
C
C
CF

(1 YTM) (1 YTM)2
(1 YTM)T 1 (1 YTM)T

Interpretation: YTM is the return the bond holder will earn on the

bond if he buys it at the market price and hold the bond until it
matures.

DCF Valuation 12

Valuing Bonds
Example: Find the PV (as of January 1, 2004) of a 6.375% coupon
Treasury bond with semi-annual payments, and a maturity date of
December 2009 if the YTM is 5%. The face value is $1,000.
Coupon payment every six months: (0.06375/2)($1,000)=$31.875
Time to maturity (number of half years): (2)(6)=12
Discount rate: R =0.05/2 =0.025
On January 1, 2004 the size and timing of the cash flow is:

1/1/04

$31.875

$31.875

6/30/04

12/31/04

Therefore, PV

$31.875
6/30/09

$1,031.875
12/31/09

$1,000
$31.875
1
1

$1,070.52

12
12
0.025 (1.025) (1.025)
DCF Valuation 13

Valuing Stocks
Present value of a common stock
When information on dividend payments, Dt, is available, a stocks

value per share at the current time (time t=0) is:

P0

D3
Dt
D1
D2

...

t 1 R t
1 R 1 R 2 1 R 3

where R is the appropriate constant discount rate.

Difficulty in stock valuation

High uncertainty in future dividend payments

There is no maturity (N )
Simplifying assumptions (see following slides) are often made on

dividend payments.
DCF Valuation 14

Valuing Stocks
Constant dividend payment
When future cash flows are constant, the value of the stock is the
present value of a perpetuity of constant dividend payment:

P0 =

D
R

Dividends growing at a constant rate

With constant growth rate, g, future cash flows are
D1 =(1+g)D0 , D2 =(1+g)D1 = (1+g)2D0 ,

...

The value of the stock is the present value of a growing perpetuity:

P0 =

D1
Rg

where R > g
DCF Valuation 15

Valuing Stocks
Dividends grow at differing rates in foreseeable future
Assume that dividends grow at a different rate for the first T years,
and then grow at a constant rate. The growth rate is g1, g2, gT for
t T, and is g (constant) for t > T.
D1 = D0 1 + g1
D2 = D0 1 + g1 1 + g 2

DT = D0 1 + g1 1 + g 2 1 + g T
DT+1 = D0 1 + g1 1 + g 2 1 + g T 1 + g

Then, the price formula is:

T

P0
t 1

D0 G t
1
D T 1

1 R t 1 R T R g

where G t 1 g1 1 g 2 ...1 g t
DCF Valuation 16

Valuing Stocks
Example
(Non-constant growth plus perpetuity) Your firm is about to make its
initial public offering of stock and your job is to estimate the correct
offer price. Forecast dividends are as follows:
_____________________________________________________
Year

Dividend per share

$1.50
$1.67 $1.82
5% thereafter
_____________________________________________________

If investors demand a 10% return on investments of this risk level,

what price will they be willing to pay?

DCF Valuation 17

Valuing Stocks
First, start with the cash flow remaining after year 3, which is a growing
perpetuity with the first payment of $1.821.05. So if you sell the stock at
the end of year 3, you would charge the following price:

P3

1.82 1.05
$38.22
0.10 0.05

Then, the original cash flow is then changed as:

________________________________________________________
Year
Cash flow per share

1
$1.50

2
$1.67

3
$1.82+38.22

4
0

________________________________________________________
We thus obtain the stocks offering price:

P0

$1.50 $1.67 $1.82 $38.22

$32.83
2
3
(1.10) (1.10)
(1.10)
DCF Valuation 18

Valuing Firms
The fair market value
This is our main focus: the firms true value
Firm value = PV(Expected cash flows to owners and creditors)
It presents the firms intrinsic value, which is different from the
companys book value or even the current market value.
With equity and debt capital (at the moment)
Firm value = Value of equity + Value of debt
Value of equity = Firm value Value of debt
When the value of debt is known, the firms value determines the
firms equity value.
DCF Valuation 19

Valuing Firms
Levered and unlevered cash flows
Unlevered cash flows
Unlevered CF is from a fully equity-financed project or business. A firm
with no debt capital is fully equity financed and is unlevered.

A firms free cash flows are unlevered, which do not depend on the
firms financial leverage.

Levered cash flows to equity

By using debt, a project or business becomes levered. The levered
cash flows include the benefit from tax savings on interest expenses.
Hence, a levered firms risk and value are affected by debt.

DCF Valuation 20

The Cost of Capital (WACC) Approach

Valuation formula
The fair value of the firm is obtained by discounting the unlevered

cash flow (or FCF) using the overall cost of capital, WACC. With
capital consisting of equity and debt:

Value of Firm =
t=1

FCFt
,
1 + WACC t

E
D
WACC =
R +
R 1 TC
E+D E E+D D

For perpetual cash flows of constant growth

FCF1
Value of Firm =
WACC g n
where, FCF1 is next years cash flow;

gn is indefinite constant growth rate.

DCF Valuation 21

The Cost of Capital (WACC) Approach

Value of equity

Value of Equity =
t=1

FCFt
Value of Debt
1 + WACC t

NPV from purchasing the firm

NPV =
t=1

FCFt
Total Investment
t
1 + WACC

Note that WACC is constant

DCF Valuation 22

The Cost of Capital (WACC) Approach

Example: project valuation
Pearson Company is considering a project. If the project is all-equity
financed, the incremental after-tax cash flow is:

$1,000
0

$125
1

$250

$375

$1,460
4

Person plans to use $600 of debt at RD = 8%, so the equity holders

only have to come up with $400 of the initial $1,000. Pearsons tax
rate is 40%, and the cost of equity with target debt-to-equity ratio
0.72 is RE=20%. Should Pearson accept the project?

DCF Valuation 23

The Cost of Capital (WACC) Approach

With D/E = 0.72, the overall cost of capital is:
WACC

1
0.72
20%
8% 1 0.4 13.64%
0.72 1
0.72 1

With the unlevered cash flows, the value of the project is:

PV

$125
$250
$375
$1,460

$1,435
(1.1364 ) (1.1364 ) 2 (1.1364 )3 (1.1364 ) 4

The NPV of the project:

NPV $1,000

$125
$250
$375
$1,460

$435
2
3
4
(1.1364) (1.1364)
(1.1364) (1.1364)

DCF Valuation 24

Terminal Value
Terminal-value (TV) valuation model
Since we cannot estimate cash flows forever, we estimate cash

flows for a growth (or planning) period, and then estimate the
terminal value to capture the value at the end of the period.
General formula
n

Value of Firm =
t=1

FCFt
1 + WACC

TVn
+
1 + WACC

where the terminal value is the present value at time T (forecast

horizon) of all cash flows after this point, FCFn+1, FCFn+2,

DCF Valuation 25

How important is terminal value?

DCF Valuation 26

Terminal Value
Estimating TV
Stable growth model: using DCF by assuming that cash flows,
beyond the terminal year, will grow at a constant rate forever.
Multiple approach: applying a multiple (e.g., the value-to-EBIT
ratio) to year n (to be discussed).
Liquidation value approach (less useful): assuming that the firm
will cease operations at a point in time in the future and sell the
assets it has accumulated to the highest bidders.

DCF Valuation 27

Terminal Value
Stable growth model

CFn+1
TVn =
WACC g n
Setting the forecast horizon, n
Maturity of business: The perpetuity-based TV estimator assumes
the maturity of business. It is essential to understand the life cycle of
business, and set the forecast horizon from which in the future
stable growth begins.
This time point depends on individual firms business and its stage
of development (next slide).

DCF Valuation 28

Examples of Projected Cash Flows by Investment

Projected Cash Flows by Investment

350
300
250

Millions of Dollars

200
150
Movie Studio
100

Bottling Plant
Toll Road

50
0
1

11

13

15

17

19

21

23

25

27

29

-50
-100
-150
Year

DCF Valuation 29

Terminal Value
Determining the stable growth rate, gn
The expected long-term growth rate of the economy as a proxy
A commonly used approach: the Fisher formula

1 + g = 1 + g real 1 + g inflation

g g real + g inflation

Inflation: based on general knowledge of the economy

Real growth: based on population and economic growth
Distinguishing between domestic and international markets.

The firms sustainable growth rate can also be useful.

DCF Valuation 30

Adjusted Present Value (APV) Approach

The value of a firm can be thought as the value of the
unlevered firm plus the value of debt financing (VDF, which
is the present value of tax benefits of debt):
Value of firm = Unlevered value + VDF
APV deals with the two components separately
Estimating the unlevered value by discounting the expected free
cash flows at the unlevered cost of capital.

Estimating VDF by discounting interest tax savings at the

appropriate discount rate, and taking into account any expected
bankruptcy costs.

DCF Valuation 31

Adjusted Present Value (APV) Approach

Estimating the value of the unlevered firm
Estimate the unlevered cash flows (the firms free cash flows).
Determine the unlevered cost of capital, R0, and use it to obtain the
unlevered value: R 0 = R F + Unlevered MRP

Estimating the tax benefit (and cost) from borrowing

Discount tax saving CFs using the appropriate discount rate to obtain VDF.
For constant perpetuity debt: VDF = D Tax rate

Compute the expected bankruptcy cost if possible

With the probability of bankruptcy, p, the expected (direct and indirect) costs is
calculated as:
E(Bankruptcy costs) = p PV of bankruptcy costs
DCF Valuation 32

Adjusted Present Value (APV) Approach

Example
J. Crew is a U.S. retailer that sells clothes made under its brand name
through its own stores online. In 2010 the firm was acquired via a
leveraged buyout (LBO) for $2.7b, with $1.85b coming from debt (with a
rating of BB and a pre-tax cost of debt of 7%). The debt balance of
$1.85b is to be repaid in equal amounts per year down to a level of
$500m from the beginning of year 10. It will remain at this balance in
perpetuity.
Assume that the firms free cash in 2010 was $149.5 million and will
grow at constant rate of 3.5% in perpetuity, and the tax rate is 35%.
Assume an unlevered beta for similar firms of 1, a risk-free rate of 3.5%,
and a market risk premium of 6.4%. Evaluate the acquisition value using
the APV approach.

DCF Valuation 33

Adjusted Present Value (APV) Approach

Estimating the value of the unlevered firm
Next years unlevered cash flow: $149.5(1+3.5%) = $154.73b
Unlevered cost of capital: 3.5% + 16.4% = 9.9%
Value of the unlevered firm: 154.73/(9.9% - 3.5%) = $2,418 million

Estimating the tax benefit of debt financing

Initial debt: $1,850 million
Principal repayment of (1,850-500)/9=$150m each year for 9 years

Declining interest expenses and tax savings for first 9 years

Perpetual tax savings since year 10 (or 2021)
Present value of all tax savings @ kd = $305 million (next slide)

DCF Valuation 34

Adjusted Present Value (APV) Approach

Year
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
Perpetuity

Debt due at
start of year

Interest
expense

Tax saving

$1,850
$1,700
$1,550
$1,400
$1,250
$1,100
$950
$800
$650
$500
$500

$129.50
$119.00
$108.50
$98.00
$87.50
$77.00
$66.50
$56.00
$45.50
$35.00
$35.00

$45.33
$41.65
$37.98
$34.30
$30.63
$26.95
$23.28
$19.60
$15.93
$12.25
$12.25

PV of tax
saving
42.36
36.38
31.00
26.17
21.84
17.96
14.49
11.41
8.66
6.23
88.96
305.45

DCF Valuation 35

Adjusted Present Value (APV) Approach

Firm value without bankruptcy costs
$2,418 + $305 = $2,723 million

Firm value with expected bankruptcy costs

Assume that bankruptcy costs would amount to 30% of firm value and
that the high debt level taken in the deal increases the probability of
bankruptcy to 20%. Then,
Expected bankruptcy costs = 2,723(30%)(20%) = $163 million

Firm value = 2,418 + 305 163 = $2,560 million

What do the results mean about the price paid by the investors?

DCF Valuation 36

WACC vs. APV

The WACC approach
Interest tax shields are included in WACC.
WACC changes with capital structure.
Convenient to use when WACC is roughly constant
Suitable for normal level of debt and stable capital structure

The APV approach

Interest tax shields are separated from unlevered cash flows.
Discount rates are treat as constant.
Convenient to use for high and time-varying capital structure
Suitable for leveraged buyout (LBO) valuation

DCF Valuation 37

Free Cash Flow to Equity (FCFE) Approach

Valuing equity directly
Discounting dividend payments value of equity per share
Firm value (e.g. by WACC), D value of firms total equity
Discounting cash flow to equity value of firms total equity

Calculating free cash flow to equity (FCFE)

FCFE = FCF Net cash flow to creditors
= FCF (Debt repayments New debt issued)
= FCF (Principal + After-tax interest New debt)
FCF: firms free cash flow (which is unlevered)
After-tax interest expense in a year: D RD (1 Tax rate)

DCF Valuation 38

Free Cash Flow to Equity (FCFE) Approach

Valuation formula
The fair value of the firms total equity is obtained by discounting
the (levered) FCFE by the (levered) cost of equity, RE .

Value of Equity (E) =

=1

FCFEt
1 + RE

NPV (to equityholders) = Value of equity Initial equity investment

Equity value per share =

Value of equity
Number of outstanding shares

DCF Valuation 39

Free Cash Flow to Equity (FCFE) Approach

Example (from the WACC approach example)
To determine the cash flow to equity, we need to calculate the after-tax

interest expense each year:

DRD(1 Tax rate) = $6000.08(1 0.40) = $28.80
Year

-1,000

125

250

375

1,460

Cash flow to creditors

-600

28.8

28.8

28.8

628.8

Cash flow to equity

-400

96.2

221.2

346.2

831.2

Unlevered cash flow

The value of the levered cash flows is:

96.20 221.20 346.20 831.20

Value of Equity =
+
+
+
= $835
1.2
1.2 2
1.2 3
1.2 4
NPV = 835 400 = $435
DCF Valuation 40