Ubs - DCF PDF
Ubs - DCF PDF
Ubs - DCF PDF
The advantage of a DCF valuation is that it allows the free cash flows that occur
in all future years to be valued giving the 'true' or 'intrinsic' value of the business.
The disadvantage is that it requires accurate forecasts of future free cash flows
and discount rates. Typically, explicit free cash flow forecasts are produced for 5 to
10 years. However, in general, the bulk (often 80% or more) of the value lies
beyond this explicit forecast period, and this is captured in a terminal value
calculation. The accuracy of this calculation is not only a function of the method
used and the underlying assumptions, but also the level of cash flow at the end of
the explicit forecast period.
Traditional valuation multiples are often used to calculate terminal value.
However, it is difficult to estimate the fair value multiple for the company some 5
to 10 years hence, and this introduces an unacceptable level of inaccuracy.
A better approach to terminal value is to represent the free cash flows
beyond the explicit forecast period in terms of a terminal growth rate and continue
the DCF analysis in perpetuity. This growth must be consistent with the level of
investment and return on investment, an issue which is often overlooked. An
alternative is to treat the company as a cash cow and assume a decay rate in the
gross cash flows, this eliminates the need to assess the ongoing level of investment.
With these points in mind, a DCF analysis can be used in three
ways: (1) As a measure of absolute value. A DCF analysis will provide an absolute
value and it is always useful to 'sense check' this against an implied traditional
multiple (eg EV/EBITDA, PE, P/BV, etc). (2) As a tool in scenario analysis. These
scenarios should reflect company specific factors rather than macro factors, which
affect the value of all other companies in the market as well as the company being
valued. Each scenario should use the same discount rate. (3) In a calculation of an
implied discount rate based on current price and forecast free cash flows. This
discount rate can be compared with those of other companies and/or a theoretical
discount rate. This approach has the advantage that it permits relative valuations.
John Wilson
Tel (+44) 171 901 3319 Overall, DCF valuations provide a more rigorous valuation approach than
[email protected]
traditional techniques.
101150 Tel (+44) 171 901 3333, Fax (+44) 171 901 2345
UBS Global Research Valuation Series
Contents
Overview 4
Effects of errors 16
Part 3: Appendices 27
Part 1
Practical guide to DCF
valuation
Overview
also be subtracted from the DCF value to calculate equity value. Great care should
be taken under these circumstances to ensure the correct discount rate is used.
In general, DCF valuations give an absolute value and, therefore, the issue of
comparators does not exist as it does with other techniques. However, a problem
with using DCFs for calculating absolute values is that analysts’ forecasts may be in
error. In general, these errors tend to be systematic rather than random. Under
these circumstances, DCFs are best suited to assessing the percentage differences
between the values of various strategies as these differences will be unaffected by
systematic errors. Finally, if the DCF technique is used to calculate an implied
discount rate this can be compared with the implied discount rate for other stocks.
Where should DCF be used?
In theory, a DCF analysis is applicable to any company, however, certain practical
difficulties exist. As a DCF valuation requires cash flows to be forecast over fairly
long periods, the technique is difficult to apply if cash flows are highly cyclical,
volatile or subject to dislocations. This said, other techniques also suffer from
problems in these situations and a DCF approach is by no means any worse than
other techniques and, in general, a lot better. One reason the technique is better is
that the analyst is forced to explicitly forecast the cash flow profile and, therefore,
address the business and strategic issues faced by the company.
DCF analysis is most suited The industries that most lend themselves to a DCF analysis are those with stable,
to stable companies forecastable cash flows and systematic risks that are easily defined.
What influences DCF valuations?
The valuation is influenced A DCF valuation is influenced by the forecast cash flow profile and the cost of
by the explicit cash flow capital that is used to bring that profile into present value terms. The forecast cash
forecasts... flow profile is, obviously, influenced by the quality of the analyst’s model and the
quality of input assumptions. While the former is a mechanical quality, the latter is
...cost of capital... a cerebral quality. The second influence on value is the cost of capital and this too
requires a degree of mechanical calculation and cerebral input.
...and terminal value In practice, cash flows cannot be forecast for all time and, therefore, some assumptions
are made as to the cash flow characteristics beyond the explicit forecast period.
These assumptions are used to calculate a terminal value and clearly these too will
influence the calculation of value.
Most DCF valuations break down because cash flow forecasts are poor, terminal
value calculations are inappropriate and discount rates are not estimated properly.
Advantages and disadvantages of DCF valuation
The main advantages of a DCF analysis is that it allows different cash flow profiles
to be explicitly valued. Offsetting this very significant advantage is the effect that
small errors in the forecast cash flow profile and discount rate will have on calculated
value.
A summary of the main advantages and disadvantages of a DCF valuation are given
in Table 1.
~ Theoretically correct ~Accurate forecasts are required (this includes forecasts of capital
spend on assets, investments or acquisitions)
~ Forces the analyst to be ~Care needs to be taken in identifying claims on the business
rigorous in modelling future other than debt and equity, such as pensions
cash flows
~ Explicitly takes account of the ~Requires accurate estimate of the (after-tax) cost of capital
value impact of future profile
of cash flows
~Little consensus between users of the technique on the method
of calculating, or the level of, the cost of capital
~Easily abused by unscrupulous users
~Often seen as inaccessible by anyone other than the valuer
~Often over 80% of the value lies beyond the explicit forecast
period and this value is calculated using terminal value
techniques, these techniques are at best approximate and at
worst totally inappropriate.
* These items are often neglected, however, the cash flows must be based on a thorough forecast for the
company and should include the effect of matured debt, conversion of convertible loan notes, exercise of share
options etc.
** This is not part of the corporate cash flow but must be included for consistency with the calculation of WACC
(see UBS valuation series: cost of equity and capital).
*** This is not part of the corporate cash flow but is included for consistency with the calculation of the COE
(COE is a gross return, see UBS valuation series: cost of equity and capital).
****Preferred cash flow for discounting purposes.
If cash flows are stated before any item other than net interest and dividends then
the capitalised value of this item together with the capitalised value of net interest
(ie net debt) should be subtracted from the DCF value to determine the equity
value. For example if an analyst believed a company faced a windfall profit tax at
some point in the future but was uncertain as to the timing of the cash out flow, the
tax could be ignored providing the present value of the tax was subtracted from the
DCF value. Of course, if timing is unknown it is difficult to accurately calculate
present value, however, a guesstimate is usually satisfactory.
There is an important point here; if the cash outflow is not model, then the model
may add value to (or subtract value from) the 'phantom' retained cash. Clearly, in
the example above, not only should the present value of the tax be subtracted from
the DCF value but also the present value of the value added to (or taken from) the
'phantom' retained cash. While we have considered a windfall profit tax there are
many similar one-off or multi-year charges that are intentionally omitted from the
cash flow forecast. Where this happens, DCF value needs to be adjusted.
Cost of equity
...so is the cost of equity - The cost of equity is the total return demanded by equity investors on their
although the risk premium investment. Investors will demand higher returns on their investments as the risk to
is quite different those returns increases and vice versa. This risk/reward relationship is a fundamental
concept used in calculating the cost of equity. A common way of expressing this
relationship is via a model known as the capital asset pricing model (CAPM). This
model, which is discussed in more detail in the UBS Valuation Series: Cost of equity
and of capital, breaks down the return into two principal components:
~ The returns on ‘risk free’ investments (government debt). This is generally known
as the risk free rate (Rf).
~ The additional return required to compensate for the uncertainty associated
with investing in the company.
This latter component is further broken down into two parts:
~ The return that the market as a whole will deliver over and above the risk free
rate. This is known as the market risk premium (Rp).
~ The risk of the company relative to that of the market. This is known as the
company’s beta (β). This risk represents both the sensitivity of the underlying
business (systematic business risk) to macro influences and the risk to equity
investors from the capital structure of the company (financial risk).
The way these components are combined is straightforward and is shown in the
equation below:
COE = RF + β . RP
Risk-free rate is taken as The risk-free rate is based on the 10-year maturity government bond. There are
the 10-year maturity many arguments to support longer-dated bonds. However, provided the same bond
government bond is used to determine the risk-free rate and as part of the market premium calculation,
the differences in the final value for COE are relatively immaterial. It is simply
convenient to use a 10-year bond because they are available in all European markets.
Market risk premium
The market risk premium We take the risk premium as a forward-looking premium based on the expected
is the difference between long-run returns of the market (a detailed description of the calculation of the
the expected market return
market risk premium is given in the UBS Valuation Series: Cost of equity and of
and the risk-free rate
capital less the risk-free rate (see previous section). Typically, this varies between
2% and 4% depending on the market.
Each quarter, UBS will publish the risk-free rate and the forward-looking risk
premium for the key European markets in its regular strategy document entitled
‘European Equity Market Indicators’, which is also available on our web page:
www.ubs.com/research.
β)
Beta (β
The risk factor is calculated The final component of the COE calculation is the risk measure (beta or β). We
by the analyst based on... estimate, within certain guidelines, a forward looking β. To introduce some
consistency into the calculation of β across various sectors and countries, we base
the risk measurement on two factors:
* The systematic business risks relative to the ‘average’ company in the market.
** Based on market values of debt and equity.
*** The financial risk adjustment assumes a gearing level (based on market values) of 20% for the market. If
economic gearing differs from this then for each 20 percentage points of company gearing above/below the
market the financial risk adjustment can be taken as +/-0.1.
In using Table 4, if there is a significant change in gearing over the forecast period
then the analyst should adjust the COE for these changes.
Cost of other types of capital
...cost of other types of While we have considered equity and debt finance, other types of finance can be
capital need to be used eg; preference shares, convertibles, etc. These types of finance will share some
considered
of the characteristics of equity and of debt and it is best to cost them on this basis.
A simple alternative, where the other instruments are not a significant part (ie less
than 10%) of the capital base, is to assign each type of instrument to either debt or
equity.
Terminal value
Terminal value sometimes, The cash flows must be based on a thorough forecast for the company and should
but not always, needs to be include the effect of matured debt, conversion of convertible loan notes, exercise of
fully diluted
share options etc. To the extent that these do not occur during the explicit forecast
periods the terminal value should be calculated on a diluted basis. We use one of
two approaches to terminal value, more approaches are discussed in
Part 2: Calculating terminal value.
Constant cash flow growth
Terminal value is often By considering the growth in free cash flow (cash flow after capex and after tax but
based on the assumption before interest and dividend) beyond the end of the explicit forecast period T to be
that the long run free cash
constant, we can calculate the terminal value. This is shown in the Table 5.
flow growth is constant...
* The terminal value still needs to be brought into present value terms by dividing by (1 + WACC)T
** Value is infinite if long term growth is equal to or greater than the discount rate!
...long run growth can be An important variable in the terminal value calculation is the long run growth in
based on growth in the free cash flow. Small errors in the estimation of this growth rate can have a huge
underlying market... input on the terminal value, particularly for high-growth companies. As an example,
the terminal enterprise value for a long-term growth of 8% and discount rate of
10% would be 50% more than that of the same company but assuming a long-
term growth rate of 7%. Moreover, if net debt amounted to half of the enterprise
value of the 7% growth scenarios, the equity value of growth was assured to be 8%
would be twice that of the 7% case.
Unfortunately, long term growth rates are often difficult to forecast, and so to is the
free cash flow. However, if we assume that after the explicit forecast period the
company is in a steady state (ie return on equity and return on capital are each
constant), the growth of the company can only be driven by the growth in net new
investment (capital expenditure over and above maintenance capital expenditure).
Thus, under steady state conditions the growth rate will be dictated by the rate of
net new investment which will be the same as, or close to, the growth rate of the
...but the capital
expenditure must be
company’s market (ie growth rate in new car sales or telephone calls or planes
consistent with this growth ordered, etc). Unfortunately, the assumed capital expenditure in the final year of
the explicit forecast is often inconsistent with the long term growth rate. In Part 2:
Calculating terminal value, we present a method (equation 11) that can be used to
calculate the capital expenditure that would be associated with the long run growth.
The formula that underlies Table 5 is given in Part 2.
Zero value added
An alternative to constant Terminal value based on ‘zero value added’ assumes that at the end of the explicit
cash flow growth is 'zero forecast period, management earn an economic return on future investments that is
value added'... identical to the cost of capital. In other words, if DM40m of the gross cash flow
(cash flow before capex, dividend and interest but after tax) is invested in new assets
...this method assumes that the present value of the future cash flows from these assets will be DM40m. On this
no value is added to basis, new investments do not add value and we can, therefore, simply discount the
investments beyond the gross cash flows from existing assets. For convenience, we assume that these cash
explicit forecast period flows decline linearly over the remaining life of the asset base. The ratio of the
terminal value to gross cash flow is given in Table 6.
* The terminal value still needs to be brought into present value terms by dividing by (1 + WACC) T, where ‘T’ is
the length (in years) of the explicit forecast period.
This approach neither A further problem with the constant growth model is the level of fuel cash flow at
requires a growth forecast the end of the explicit forecast period. In particular, the capital expenditure (the
nor a capital expenditure difference between gross and free cash flow) is often not consistent with the assumed
forecast... long-term growth rate.
... for these reasons, we The ‘zero value added’ approach to terminal value is our preferred approach as the
prefer this approach gross cash flow is easier to calculate than the free cash flow (capital expenditure
does not need to be calculated) and the remaining life of the asset base is usually
very easy to estimate. Moreover, the variation in terminal value to gross cash flow
ratio varies much less than terminal value to free cash flow. However, this whole
approach does presuppose that management neither add nor destroy value beyond
the explicit forecast period.
The formula that underlies Table 6 is given in Part 2.
Part 2
Theoretical guide
Effects of errors
While a DCF analysis will give the intrinsic value of the forecast cash flows at a
particular discount rate, neither of these two quantities is easily calculated. Moreover,
cash flows are not forecast for all time and, therefore, at the end of the explicit
forecast period, a terminal value is calculated which often relies on traditional
valuation techniques. Any one or all of these three items:
~ Cash flow forecast.
~ Terminal value.
~ Discount rate.
can be in error.
The effects of errors on value are addressed below. For convenience, the first two of
these items are treated together.
1 7 5 3 1
2 14 10 6 1
3 21 15 9 2
4 26 19 11 3
5 32 23 14 4
6 37 27 17 4
7 42 31 19 5
8 46 35 21 6
9 50 38 24 6
10 54 41 26 7
1 11 8 4 1
2 20 14 8 2
3 29 21 12 3
4 36 27 16 4
5 43 32 20 5
6 49 37 23 6
7 55 42 26 7
8 60 46 30 8
9 64 50 33 9
10 68 54 35 10
Chart 1: Same errors in the fit year forecast and terminal value
Calculated value / correct value
180%
120%
100%
80%
60%
40%
-30% -20% -10% 0% 10% 20% 30%
Error in year 5 free cash flow* and in terminal value
Zero
T 1 2 3 4..................................... L L+1
Years
From Chart 2 we can see that the value (TV) of the declining gross cash flow from
GCFFT at the end of the explicit forecast period to zero at L + 1 is given by:
n=L
GCFFT ( 1 - n / (L + 1))
TV =
å (1 + W)n (1)
n=1
Where n is the year (first year after the end of the explicit forecast period n = 1,
second year n = 2, etc), W is the weighted average cost of capital and L is the life
remaining at the end of the explicit forecast period of the longest life asset.
This equation can be re-written as:
n=L
L+1-n
å
GCFFT
TV =
L+1 (1 + W)n
n=1
or
n=L n=L
å å
GCFFT 1 n )
TV = ((L + 1) -
L+1 (1 + W)n (1 + W)n
n=1 n=1
GCFFT
TV = (( 1 + W )L .( WL - 1 ) + 1 )
W (1 + W)L (1 + L)
2 (2)
TV GCFFT . (( 1 + W L).( WL - 1 ) + 1
= (3)
(1 + W) T W2 (1 + L).(1 + W)(L + T)
Where T is the duration of the explicit forecast period in years and GCF is this
gross cash flow at the end of the explicit forecast period, W is the weighted average
cost of capital and L is the remaining life of the asset base.
Table 5 presented in part 1 gave the ratio of the terminal value to gross cash flow of
the firm. This table was based on a slight modification to equation (3); the terminal
value is not brought into present value terms and is divided by GCFF, ie:
TV = (( 1 + W L).( WL - 1 ) + 1 )
GCFFT W2 (1 + L).(1 + W)L (4)
TV FCFF (1 + g)
=
(1 + WACC)T (WACC - g) (1 + WACC)n
In this equation WACC represents the weighted average cost of capital and the
FCFF is the last forecast for the explicit forecast period.
An important variable in the terminal value calculation is the long-run growth in
free cash flow. If we assume that after the explicit forecast period the company is in
a steady state (ie return on equity and return on capital are each constant) the
growth of the company can only be driven by the growth in net new investment
(capital expenditure over and above maintenance capital expenditure). Thus, under
steady state conditions the growth rate will be dictated by the rate of net new
investment which will be the same as, or close to, the growth rate of the company’s
market (ie growth rate in new car sales or telephone calls or planes ordered, etc).
While we can determine growth in free cash flow to the firm by considering the
‘macro’ environment in which the company operates, it is helpful to ensure that the
level of free cash flow to which the growth is applied is consistent with the rate of
investment. This can be done by ensuring that the ratio of free cash flow to gross
cash flow (cash flow after capital expenditure to cash flow before capital expenditure)
is consistent with the assumed growth rate. This ratio is calculated below.
We can relate the gross cash flow (GCFF) to the gross book value (GBV) of assets
through the cash flow return on gross book value (gross cash return (GCR)), ie:
GCFF1
GCR = (5)
GBV0
While the gross cash flow return may not be a familiar concept, it is the same as the
initial EBITDA over capital employed (CE) for a project. However, for a project
EBITDA/CE will rise as the capital employed is eroded by accumulated depreciation.
Thus, the advantage of a gross cash flow return is that it provides a return figure
that is unaffected by the rate of investment and is, therefore, constant (in the absence
of changing inflation).
In addition to equation (1) we can say that the gross book value one year to the next
is related through the capital expenditure (CX) i.e:
GBV1 = GBV0 + CX1 (6)
From equation (2) we can write the growth in gross book value (which will be the
same as the growth in gross cash flow if gross cash flow return is constant) in terms
of capital expenditure.
Equation (5) can be substituted into equation (7) to give growth in terms of return
and gross cash flow:
CX1 . GCR
g= (8)
GCFF1
Finally, we know that the free cash flow to the firm (FCFF) is related to the gross
cash flow as follows:
FCFF1 = GCFF1 - CX1 (9)
therefore, substituting (9) in (8) gives:
GCFF1 - FCFF1
g= ( GCFF1 ) GCR
or in more general terms:
FCFF
g= ( 1- GCFF )
It may be more convenient to express the ratio of free cash flow to gross cash flow in
terms of growth and gross cash return:
FCFF / GCFF = 1 - g / GCR (10)
or to express the level of capital expenditure in terms of gross cash flow, growth and
cash return:
... the level of capital g . GCFF
expenditure CX = (11)
GCR
Equations (10) or (11) should be used in conjunction with the constant cash flow
growth equation to ensure the free cash flow is consistent with the forecast gross
cash flow and assumed growth.
* The tax charge is taken as P&L tax plus the interest tax shield.
** Net increase in asset is the same as net new investment or change in capital employed.
If equation (18) is substituted in the constant cash flow growth model, equation
(13), and bearing in mind that in steady state conditions gCF = gop = g, we can
write the value of the entire business under conditions of constant growth as;
NOPAT . (ROCE - g)
Fair enterprise value = (19)
ROCE . (WACC - g)
Where the net operating profit after tax (NOPAT) is for the first forecast year.
+ Present value of free cash flow over the explicit forecast period
- Present value of non-equity cash flow over the explicit forecast period
= Present value of the equity over explicit forecast period
+ Terminal value of equity based on market multiples
= Total value of equity
further reinforced if the reader bears in mind that 80% or more of the total value of
a share is represented by the terminal value and if this is based on a spurious market
multiple then there can be little confidence in the total value.
In preference to a terminal market multiple we would prefer to use the constant
cash flow growth model presented on the previous page.
An alternative to using market multiples is the use of embedded value measures. At
UBS two measures have been used:
~ Liquidation value.
~ Replacement cost.
As both of these methods focus on the value of tangible assets they are inappropriate
where there is considerable intangible assets such as people (service industries) or
brands (some consumer products based industries).
Liquidation value
Only use liquidation value Liquidation value is based on the estimated proceeds from the sale of the assets of
if the assets will be the business less the liabilities at the end of the explicit forecast period. This value is
liquidated not at all easy to calculate and is, in any event, usually highly subjective. It is often
best used in industries where the assets are in a tradable form; typically financial
assets (insurance policies for example), commodities (for example a tin mine with
definable reserves) or, to a lesser extent, land and property. The approach is not
particularly suited to businesses comprising large physical asset bases such as oil
refineries, electricity generators, shipping fleets, etc, where the liquidation value
may be nothing more than the scrap value. Finally, this approach should really only
be used if the assets are likely to be liquidated.
Replacement cost
Replacement cost is good Replacement cost can be interpreted in two ways, firstly; the cost of replacing the
but very difficult to existing assets with like assets; secondly; replacing the existing assets with assets
calculate which will provide the end customer with same product or service (economists
often refer to this method as the optimum net deprival value). An example of this
latter method would be the replacement of a fixed telecoms network with a mobile
system or the replacement of a sub optimal electricity distribution network (for
example; one that was built to distribute to industrial customers that are no longer
in existence) with an optimal one. In both approaches, the ‘new’ cost should be
depreciated to reflect the remaining economic (as opposed to accounting) life of
the assets. The replacement cost approach is particularly suited to companies that
have large physical asset bases such as chemicals companies, telecoms companies,
electricity companies etc.
Debt
...debt... There are two common ways of valuing the net debt of a business:
~ Book value of net debt.
~ Market value of net debt.
In the UK and continental Europe most analysts use the book value while in the
US most analysts use market value. There is little justification for using the book
value of debt, indeed no more than for using the book value of equity! A straight
forward way of examining this is to consider two identical companies in every
respect except that one company is funded by debt that carries a lower coupon than
the other. Clearly, the pre interest cash flows will be identical and, therefore, the
value of the businesses will be identical. However, in the case of the company that
has lower interest costs there will be more cash available for shareholders and the
value of its equity would be higher. Therefore, despite having the same book value
of debt each has a different market value of debt. The relationship between market
value and book value is shown below.
Market value of debt = book value of debt × coupon / current interest rate
It is important to note that ‘current interest rate’ in the above formula means the
current rate that would prevail for debt with a term structure that was identical to
the remaining term structure of the book debt.
In Europe, the difference between book value and market value has often been
overlooked because debt was usually issued at floating rate. With floating rate debt,
the ratio of coupon to current interest rates is unity. In the US, it is more common
for debt to be issued at fixed rate and, therefore, market value can differ from book
value. However, it is increasingly common for European companies to issue fixed
rate debt.
Unfunded liabilities
...unfunded liabilities Any liability that would be funded out of the cash flows that are used in the DCF
valuation must be removed in order to calculate the value of equity. One such
liability is the pension liability of German companies. German companies pay
pensions on a cash basis out of a pension provision that is funded through a P&L
charge. However, as the cash charge (the charge impacting cash flows) meets only
the demands of the existing pensioners a liability is created for additional future
pensioners. Of course, future cash flow forecasts could include future cash pension
charges and the growth in these could be included in the terminal value calculation.
However, rather than forecast annual cash pension over the explicit forecast periods,
it is better to state cash flows before pension costs and subtract the total present
value of the pension liability from the calculated enterprise value. Unfortunately,
where German companies have issued financial statements under US GAAP it is
clear that, in general, the balance sheet pension provision is insufficient to meet the
future pension liabilities and so the analyst will still need to estimate total pension
liability.
Part 3
Appendices
n=¥
V =
ä
n=1
Zn
(1 + DR)
n
(A:1)
Where Z is the quantity being discounted (it could be EVA, dividend or free cash
flow or a number of other measures), n denotes the year and DR is the discount
rate (usually either the weighted average cost of capital or the cost of equity or
whatever is consistent with the quantity being discounted).
When steady state conditions have been achieved, rates of return will be constant as
will growth rates.
With constant returns, growth rates will be driven by the growth in invested capital
or in equity. It is common practice to take these growth rates as the long-run growth
in the stock market unless there is a clearly justifiable reason for adopting a different
growth rate. In the next section on terminal value for EVA calculations we show
how to calculate the terminal growth rate from the conditions at the end of the
explicit forecast period. If the growth so calculated is different from that of the
market or from expectations steady-state conditions may not have been reached.
Under conditions of constant growth:
Zn = Z0 × (1 + gZ)n
Where gZ is the year on year growth rate of Z. Thus equation (A:1) becomes:
n=¥
ä
n
Z0 ´ (1 + gZ)
V = n
(1 + DR) (A:2)
n=1
The next step is to subtract equation (A:4) from equation (A:3) to give;
1
(1 + gZ) Z0 ´ (1 + gZ)
V-V´ = (A:5)
(1 + DR) (1 + DR)1
Equation (34) can be re-written as:
Z0 ´ (1 + gZ) Z1
V= = (A:6)
(DR - gZ) (DR - gZ)
Equation (A:6) is the general formula used for terminal value purposes. Remember
that when using this formula, Z0 refers to the last value of Z in the explicit forecast
period and V is the value of all future values of Z beyond the explicit forecast
period. Consequently, V needs to be converted to a present value by multiplying by
the present value factor for the last forecast year (=1/(1+DR)a) where ‘a’ typically
lies between five and 10 and represents the explicit forecast period ie between five
and 10 years.
A special case of equation (A:6) is for gZ = 0, which gives:
Z0 Z1
V= =
DR DR (A:7)
On the basis of the calculation above, the investor should opt for the £20k in four
years time.
Another way of interpreting Table 11 is to say that a guaranteed payment of £19.66k
in four year time is equivalent, to £15k now, ie:
£15k = £19.66k / (1 + 7%)^4 = £19.66k / 1.311
Where ‘^4’ means raised to the power of 4 (or multiplied by itself 4 times ie (1 +
7%) × (1 + 7%) × (1 + 7%) × (1 + 7%)).
The process of bringing the future cash payment into an equivalent money of today
(or present value) is known as discounting. The discount rate is 7% and the present
value factor is 0.763 (=1 / 1.311)
The example given above presupposes that that the investor would invest the £15k
in something that would give the same level of security that was offered by the
£20k payment in four years time. What if the investor had the opportunity to
invest now in a speculative venture that might, in four years time, have a realisable
value of £65k? While the investor has potential to make a lot more money there is
no guarantee that the potential will be realised. The most sensible thing to do is to
consider the return that would be available from some alternative investment
opportunity of similar risk. Assume that this analysis was done and that, typically,
similar investment opportunities returned 35% pa. The investor would complete
the analysis as follows:
Discount rate 35%
Present value factor 1 / ((1 + 35%)^4) = 0.301
Present value of £65k £19.57k
Clearly, the investor should not invest in the speculative venture as it is described
above.
In this example the discount rate is 35% and this is a risk adjusted discount rate
that represents the opportunity cost of capital.
1 1
12 =
(1 + dr) 1 + DR
or (1 + dr) = (1 + DR)1/12
In other words, the present value factor for a single payment after one year based on
annual discount rates must be equivalent to the present value factor for a single
payment in 12 months time based on monthly discount rates.
If we now had cash payments of ‘a’, ‘b’, ‘c’... occurring after 3, 15, 27, ...months
respectively the cumulative present value (cum pv) would be given by:
a b c
Cum pv = 3/12 + 15/12 + 27/12 + ...
(1 + DR) (1 + DR) (1 + DR)
or
1
Cum pv =
(1 + DR)
-9/12 ( (1 +a DR)1 +
b
(1 + DR)
2 + ... )
Thus, if a series of annual cash flows begin in ‘m’ months time then we can calculate
the cumulative present value as if the first payment occurred in 12 months time
and multiply this cumulative present value by (1 + DR) ^((12 - m) / 12). We term
this adjustment as ‘starting adjustment to present value’.
Mathematical note: When one number ‘raised to the power of ...’ is multiplied by
the same number raised to a different power of ... the two ‘powers’ are added eg:
42 x 43 = (4 x 4) x (4 x 4 x 4) = (4 x 4 x 4 x 4 x 4) = 45
When one number ‘raised to the power of ...’ is divided by the same number raised
to a different power the two ‘powers’ are subtracted eg:
42 / 43 = (4 x 4) / (4 x 4 x 4) = 1/4 = 4-1
Different intervals between payments
In effect, the previous section dealt with this issue. If, for example we had 3 payments
a, b and d occurring 4, 7 and 35 months from now, the cumulative present value
would be
a b c
Cum pv = 4/12 + 7/12 + 35/12
(1 + DR) (1 + DR) (1 + DR)
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