CHAPTER 5

Discounted Cash
Flow Method
DISCOUNTED CASH FLOW METHOD

 Discounted cash flows analysis can be done by

determining the present value of the net cash flows
of the investment opportunity.
 In Conceptual Framework and Accounting
Standards, the cash flows are presented and
analyzed based on their sources and activities
which are categorized as 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
asset.

Net Cash Flows is preferred as basis of valuation if any of the

following conditions are present:
q Company does not pay dividends
q Company pays dividends but the amount paid out significantly differs
from its capacity to pay dividends
q Net Cash Flows and profits are aligned within a reasonable forecast
period •
q Investor has a control perspective. If an investor can exert control over
a company, dividends can be adjusted based on the decision of the
controlling investor.
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.

q 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
q 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.
q 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.
In valuation, analysts find analyzing cash flows
and its sources helpful in understanding the
following:
q Source of financing for needed investments - The best case for firms is to
fund its investments wholly or partly through cash from operations. Heavy
reliance on external financing from lenders or shareholders may signal that
cash from operations is not enough to support the firm's long-term stability.
q Reliance on debt financing - Debt financing is an excellent financing strategy
especially for expanding companies. However, it can become a problem for a
firm if its cash from operations is insufficient to repay existing debt obligations.
The situation worsens if firms continuously refinance borrowings that come due
by another borrowing.
q Quality of earnings - Significant disparities between cash flows and income
may indicate earnings does not get converted to cash easily, suggesting low
quality.
There are two levels of Net Cash Flows:
q Net Cash Flows to the Firm - The amount made
available to both debt and equity claims against the
company.
q Net Cash Flows to Equity - Represents the amount
of cash flows made available to the equity
stockholders after deducting the net debt or the
outstanding liabilities to the creditors less available
cash balance of the company.
 Net Cash Flow to the Firm

q The net cash flows can be determined by referring to the

financial statements of the company.
q Enterprise value of a company refers to the theoretical
value of its core business activities as reflected by its net
cash flows. This is the basic premise of most corporate
valuation methodologies.
q Net cash flow only capture items that are directly related to
the operating and investing activities of the business.
Consequently, net cash flow excludes items associated with
financing activities.
Net cash flows to the firm can be computed
or derived using 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 Expense (net of Taxes) xxx
Add/Less: Adjustment in Working Capital xxx
Less: Net Investment in Fixed Capital xxx
(Purchases - Sales of Fixed Capital Investment)
Net Cash Flows to the Firm Php xxx
 q Net Income Available To Common
Shareholders.
 Basic measure of a firm's profitability which refers to the
bottom line figure in an income statement. This is the
amount left for the common shareholders after deducting all
costs, expenses, depreciation, amortization, interest, taxes
and dividends to preferred shareholders. This is an
accounting measure, meaning that non-cash items like
depreciation and amortization is also included as a
deduction to arrive at net income. However, this measure
does not include changes in working capital nor capital
investments made during the specific period which
significantly affects a firm's cash flows.
q Non-Cash Charges (Net).

 Pertains to non-cash items that are included in the

computation of net income. Analyst usually look at
the statement of cash flows to validate potential
non-cash charges. If amount in the income
statement does not match amount reflected in the
cash flows statement, it can be indicative that a
portion of that expense is non-cash.
The common non- cash items are the
following:
o Depreciation and amortization - When a firm acquires a
fixed asset like equipment or intangible asset, the initial
cash outflow is made at point of acquisition and is
presented in the balance sheet.
o Restructuring charges - Refers to the change in the
organizational structure or business model of a company
adapt to changing economic climate or business needs.
o Provisions for Doubtful Accounts - These are estimated
amount to be incurred for the customers inability to pay on
time which is cumulatively accounted under the statement
of financial position reported against the accounts
receivable.
q After-Tax Interest Expense Interest
expense (net of any tax savings)
 This interest expense is a cash flow intended for the debt
providers. In the Philippines, interest expense is a tax-
deductible expense for the company. This means that when
the company pays interest, it reduces tax to be paid. Hence,
the cash outflow is the amount of interest expense less any
tax savings. After-tax interest expense is added back to net
income since the objective of NCF is to measure the cash
flows associated with the operating activity of the business.
The impact of financing should be neutralized to arrive at
the real business value based on its operations.
q Working Capital Adjustment

 Also known as working capital, this item represents

the net investment in current assets such as
receivables and inventory reduced by current
liabilities like payables. The amount captured is
based on the movements in these accounts from
prior year.
q Investment in Fixed Capital.

 Pertains to cash outflows made to purchase or pay for

capital expenditures that are required to support existing
and future operating needs. Capital expenditures range
from property, plant and equipment necessary for
production requirements to intangible assets like trademark,
patent and copyrights. Firms expect that they will reap
benefits for more than one year as a result of these
investments. The investment in fixed capital assumes that
the projects financed acceptable and has positive net
present value.
B. From Statement of Cash Flows

 NCF can also be computed using cash flows from operating activities (in the
statement of cash flows) as the starting point. Analysts usually start from this
item since it already considers adjustment for noncash expenses and working
capital investments.
 As a refresher, the statement of cash flows classifies cash flow into three major
sections: cash flow from operating activities, cash flow from investing activities
and cash flow from financing activities.

Cash Flows from Operating Activities Php xxx

Add: Interest Expense (net of Taxes)* xxx
Less: Cash Flows from Investing Activities xxx
Net Cash Flows to the Firm Php xxx
*only if deducted from the operations
q Cash flow from operating activities

 This represents how much cash the company generated

from its operations. This shows how much cash is received
from customers and how much cash outflows are paid to
vendors. This also captures changes in current assets and
current liabilities. Normally, this is computed from net
income by considering non- cash items and working capital
changes. This is considered in computing for NCFF.
q Cash flow from investing activities

 This represents how much cash is disbursed

(received) for investments in (sale of) long-term
assets like property, plant and equipment and
strategic investments in other companies. This is
considered in computing for NCFF. If this section
reflects transactions involving financial assets, this
should be excluded.
q Cash flow from financing activities

 This represents how much cash was raised (or repaid) to

finance the company. This is not considered when
computing NCFF. This is simply because these figures will
be accounted for in the calculation of the Net Cash Flows to
the Equity.
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: Investment in Fixed Capital xxx
Net Cash Flows to the Firm Php xxx
q EBITDA or Earnings Before Interest, Taxes, Depreciation and Amortization
pertains to income before deducting interest, taxes, depreciation and
amortization expenses, net of taxes
q Tax Savings on Non-cash Charges - Non-cash charges are not typically
adjusted if NCFF starts with EBITDA. However, it is important that analyst
should check whether non-cash charges were already deducted in
computing for EBITDA or not. If deducted, then there is a need to add the
item back. If non-cash charges are not yet deducted from EBITDA, there is
no need to add it back to compute for NCFF.
 Net Cash Flow to Equity

 Net Cash Flow to Equity or NCFE refers to cash

available for common equity participants or
shareholders only after paying operating expenses,
satisfying operating and fixed capital requirements
and settling cash flow transactions involving debt
providers and preferred shareholders.
Net Cash Flows to the Firm Php 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 Php xxx

• Proceeds from Borrowing

This refers to the amount of cash received by the company as a result of
borrowing of long-term debt. Since NCFF did not include items related to
financing, it did not capture cash received by the company from lenders. Since
the cash from the borrowing is with the company already, it is added back to
NCFF and forms part of the cash flow available to common shareholders.

• Debt Service
Debt Service is the total amount used to service the loans or debt financing.
This is the total amount of loan repayment and the interest
expenses, net of income tax benefit.
• Proceeds from Issuance of Preferred Shares
Same with the debt, preferred shares as another form of
financing, other than the issuance of ordinary equity, must
also be factored in the calculation of the net cash flows
available to equity.
• Dividends on Preferred Shares.
Since payments made to preferential shareholders in the
form of dividends are outflows. This must be incorporated
in the calculation as a reduction of the net cash flows to
equity.
Similarly, given the above formula as guiding principle, NCFE can be determined 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 Expense (net of Taxes) XXX
Add/Less: Adjustment in Working Capital XXX
Less: Net Investment in Fixed Capital XXX
(Purchases - Sales of Fixed Capital Investment) 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 Php 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 Activities XXX
Net Cash Flows to the Firm XXX
Add: Proceeds from Borrowing XXX
Less: Debt Service XXX
Add: Proceeds from Preferred Shares Issuance
Less: Dividends on Preferred Shares
Net Cash Flows to the Equity XXX
XXX
Add: Proceeds from Preferred Shares Issuance XXX
Less: Dividends on Preferred Shares XXX
Net Cash Flows to the Equity Php 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: Investment in Fixed Capital 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
 Since GCBOS is assumed to operate in a long period of time to almost
perpetuity, the risk and returns are inherent to the opportunity at the end of
the projection period should also be quantified. Furthermore, the economic
value that will be generated by the assets is expected to be stable after some
point in time since the projections are reliant on certain assumptions made.
The challenge for the determination of the value of the asset is to also
account for the economic returns that it will generate in perpetuity. This is
addressed by the Terminal Value. Terminal Value represents the value of the
company in perpetuity or in a going concern environment. In practice, there
are several ways on how to determine the terminal value.
 BASIS OF TERMINAL VALUE

1. Liquidation Value
Some analysts find that the terminal value be based on the estimated
salvage value of the assets. Methodologies on how to determine the salvage
or liquidation value was discussed in Chapter 3.
2. Estimated Perpetual Value
Another way to determine the terminal value is by using the farthest cash
flows you can estimate divided by the cost of capital less the growth rate
3. Constant Growth
Challenges for some valuators is to determine the amount of required return
for a specific type of asset or investment. In lieu of the required return, they
use the growth rate as the proxy especially if the growth is constant and
significant.
4. Scientific Estimates
Other valuators especially those with vast experience already in some types
of investments uses other basis for them to determine the reasonable
terminal value. Using guesstimates is not prevented because in the end,
equity values will still be based on negotiation.

Other inputs in the Net Cash Flows

The present value of the Net Cash Flows represents the value of the assets. It
may be recalled further that the assets are financed by debt and equity. Hence,
these are the claims which are presented at the right side of the Statement of
Financial Position, under an account form of reporting.
DCF Analysis is most applicable to use when
the following are available:

 Validated Operational and

Financial Information
 Reasonable appropriated
cost of capital or required
rate of return
 New quantifiable
information
Financial Models in Discounted Cash Flows
Analysis
 Financial Modelling is a sophisticated and confidential
activity in a company or for an analyst. Information is
can also be considered as competitive advantage of a
company or a person. Most of the companies hire
financial modelers to assist them in determining the
value of GCBOs or other opportunities. They also ask
them to validate ballpark estimates and may also be
used to determine impairments. Most financial
modelers have extensive financial acumen and vast
knowledge and experience. Financial modelers
normally are economists, financial managers, and
accountants. Management accountants are good
candidate for this role given their ability to
understand operational models and design long term
financial strategies.
In order to develop financial models, the following steps
needs to be observed:

1. 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 the
following: audited financial statements, corporate disclosures, contracts, and peer
information.

Audited Financial Statements are the most ideal reference for the historical
performance of the company.
Corporate disclosures are also key in developing the financial model. Corporate
disclosures provide more context for the future plans and strategies of the company.
Contracts are formal agreements between parties.
Peer information and other public information are also essential inputs to the
financial model. Peer information provides more context and even supports the risks
identified or will be assumed in the valuation process.
2. Establish drivers for growth and assumptions
Once all relevant information was gathered and validated, drivers and
assumptions can be established by conducting financial analysis. Drivers are
suggested to be those validated and is represented by authorities like
government or experts. Growth drivers are normally based on population,
since most of the businesses are consumer goods. If services, industry growth
may be used as a driver. In the Philippines, information is available from the
Philippine Statistics Authority. Because the government needs to be
transparent to its citizens, it fortunate that the information can be found in
the government website or is disclosed to public through media with wider
reach and scale.
For other economic factors,
drivers, and estimates, Bangko
Sentral ng Pilipinas and
National Economic and
Development Authority are also
other agencies that can be
relied with. Certain statistical
information can also be found
from the websites or research
centers of the Local
Government Units and National
Government Agencies. Research
organizations may also be used,
however, strong validation and
The usual growth indicators used are: The consumer price index represents the
inflation, population growth, GNP or price of the basket of commodities for a
GDP growth. In economics, the particular period. In financial modelling, you
inflation is the result of the need the inflation to be used as driver for
certain operating and capital expenditures.
movement of prices from a year to
There are two ways to calculate the value:
another. This is calculated by (1) nominal and (2) real.
comparing the movement of the price
of the basket of commodities from a • Nominal financial models - are already in
year to another or a period to another. current prices, meaning, the prices stated
Inflation is computed using this in the model already assumes that the
formula: prices grew or decline, in the case of
inflation or deflation respectively.
• Real financial model - on the other hand,
does not include the effect of changes in
prices, but rather preserve the price of
operating expenses and capital
expenditures, as if no changes in prices
occur
3. 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.
4. 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 techniques like Internal Rate of Return,
Profitability Index etc.
For example, Delight Bakery Inc. projected volume of pan de sal to be sold
in Year 1 is 138,915 units, assuming 5% growth every year, and the estimated
required return of 10%. The pan de sal is sold at Php15 per unit with a cash
net income margin of 20%. Delight's equipment is capable of producing the
volume required for 10 years. It was noted that the company has outstanding
debt of Php500,000.
Using the inputs, the financial model may
be presented through:
Observe that the enterprise value is calculated by getting the sum of
all discounted net cash flows. Alternatively, NPV function can be
used in electronic spreadsheets. Below is an illustration where both
should arrive at the same results.
5. Make scenarios and sensitivity analysis based on the results.
The advantage of having a financial model is that you can easily tweak the given
information and get the results immediately. For instance, in the previous
illustration the cost of capital used is 10%. How about if you find that cost of
capital will be 12% or 15%, what will be the Enterprise Value?
If this is the case, we need to design the financial model to accommodate this
through the use of Data Table feature in Microsoft Excel. First, design a table
where the values will be inputted.
Next, select the table we prepared by highlighting cells C17 to D19 and you go
to DATA Tab and go to 'What if' Analysis then select 'Data Table'.
Components of Financial Model

 As a quick guide in developing a financial model the following components

are recommended, particularly when using Microsoft Excel:
q Title Page
This provides an overview and the project being valued or assessed. This
includes also necessary information to secure the proprietary rights of the
modeler or the firm he or she is working with. It may also include data cut-off
to serve as a guide to the readers
q Data Key Results
This sheet summarizes the results of the study. This will serve as the
dashboard to enable the modelers to analyze the results and to facilitate the
readers' appreciation on the results of the project. This also facilitate
preparation of pertinent reports.
This also contains the valuation results, scenarios, and sensitivity analysis.
Graphs can also be found in this sheet.
q Assumption Sheet
This sheet summarizes the assumptions used in the model. This is normally
an input sheet where all inputs should be made. The information that can be
found in this sheet must be linked to all the output sheets like Pro-forma
Financial Statements, Supporting Schedules and Data Key Results.
q Pro-forma Financial Statements
This presents the 3 components of the financial statements namely:
Statement of Income, Statement of Financial Position and Statement of Cash
Flows. In this sheet, you can also find some key financial ratios particularly
those that has to do with financial performance and efficiency ratios.
q Supporting Schedules
This is like a subsidiary ledger which provides supporting computation to the
components of the pro forma financial statements. There is no limit for the
supporting schedules the only challenge is that the electronic financial
models consume large amount of data because of the supporting schedules.