DCF models

Hemchand Jaichandran
Other DCF models

 Enterprise DCF model.( The enterprise DCF model discounts the free
cash flow to the firm (FCFF) at the weighted average cost of capital. )
 Equity DCF model
 Adjusted Present value model
 Economic profit model
EQUITY DCF model –Dividend
discount model
 Zero growth model. It assumes that the dividends remain constant
year after year. (P = D/r where r is the expected rate of return)
 Constant growth model: One of the most popular dividend discount
models assumes that the dividend per share grows at a constant rate
(g). (P0 = D1/r-g)
 Two stage growth model: The simplest extension of the constant
growth model assumes that the extraordinary growth (good or bad)
will continue for a finite number of years and thereafter normal
growth rate will prevail indefinitely.
Applicability of Dividend discount
model
 The model is simple and intuitively appealing.
 Fewer assumptions are required to forecast dividends
 Firms normally pursue a smoothed dividend policy.
Equity DCF model .Free cash flow to
equity (FCFE) model
 The FCFE is the cash flow left for equity shareholders after the firm
has covered its capital expenditure and working capital needs and
met all its obligations toward lenders and preference shareholders.
 FCFE = (Profit after tax – Preference dividend) – (Capital expenditure –
Depreciation) – (Change in net working capital) + (New debt issue –
Debt repayment) + (New preference issue – Preference repayment) –
(Change in investment in marketable securities)
FCFE model

 The free cash flow to equity (FCFE) model may be viewed as an

extension of the dividend discount model in which we discount
potential dividends instead of actual dividends.
 The FCFE model implicitly assumes that the FCFE will be paid out to
shareholders. This means that there will be no surplus cash build up in
the firm. So, the expected growth in FCFE will reflect only growth in
income from operating assets. They are the assets that go directly to
supporting business operations and generating income. (Cash,
accounts receivable, prepaid expenses, Fixed assets, Tangible and
intangible assets).Essentially, the FCFE model, when applied to a listed
company, assumes that there is an excellent corporate governance
system in place. Even if managers do not pay the entire FCFE as
dividends, they ensure that the cash that is held back is not deployed
uneconomically.
Problem – Calculate FCFE for years
4 -8
Solution –FCFE calculation
Calculation of Equity Value

 Find the Equity value assuming a discount rate of 18.27% and a

growth rate of 10%.
 Step 1: Discount the FCFE for year 4 to 8 at 18.27%.
 Step 2: Calculate the terminal value by using constant growth model
 Step 3: Calculate the total of discounted values from 4 to 8 years
 Step 4: Discount the terminal value to arrive at present value
 Step 5: Take total of 2 and 4.
Solution

 15/1.1827 + 15/10.71 + 15/9.09 + 16/1.96

 16/0.0827 = 193.47/1.96 = 98.70 = 139.39
 Equity value will be 137.86 million.
Adjusted present value model

 In situations where the capital structure of the firm is likely to

substantially change over time, the adjusted present value (or APV)
approach is more appropriate. The APV approach defines enterprise
value as the sum of two components:
 Value of unlevered equity free cash flows + Value of the interest tax
shield
 The first component on the right hand side of the above equation is
the present value of the firm’s operating cash flows. Since operating
cash flows do not depend on how the firm is financed, they may be
referred to as the unlevered equity free cash flows. The second
component on the right hand side of the above equation is the
present value of the interest tax shields arising from the use of debt
financing.
Procedure

 Step 1: Estimate the present value of cash flow during planning

period using the cost of unlevered equity as the discount rate.
 Step 2. Estimate the terminal value of the firm at the end of the
planning period using constant growth model and WACC, ‘g’ being the
perpetual growth rate beyond the planning period.
 (FCFF(1+g)/(WACC –g)
 Step 3. Arrive at present value of terminal value calculated under 2.
 Step 4. Add 1 and 3.
Illustration – Projections for Optex
ltd.
 Years 1 2
3 4 5
 FCFF 200 250 300 340 380
Interest bearing debt 500 400 300 200 100
Interest expense 60
Calculate the enterprise value of Optex using the following assumptions
Beyond year 5, FCFF will grow at a constant rate of 10% per annum.
Optex unlevered cost of equity is 14%. After year 5, Optex will maintain Debt
Equity ratio of 4:7
The borrowing rate for Optex is 12%
Tax rate is 30%. Risk rate is 8% and market risk premium is 6%.
Steps for calculation
 Calculate the present value of FCFF for five years discounting by cost
of equity.
 Calculate the present value of tax shield (Interest expense * Tax rate)
discounting by cost of borrowing.
 Calculate WACC. For this we have to calculate first unlevered beta
and then levered beta.
 Arrive at cost of levered equity using levered beta figure. Cost of debt
is already available.
Calculation of value of firm

 Cost of equity = Risk free rate + Beta (Market risk premium)

 14 = 8 + Beta* 6.
 So Beta = 1.00
 Calculation of levered beta
 Levered beta = Unlevered beta * 1+(1-taxrate) * D/E
 Levered beta = 1* (1+ (1-tax rate) * 4/7 = 1+( 0.7 *4/7) = 1*1.4
Calculation of Expected return on
Equity
 Expected return on equity = 0.08 + 1.4(.06) = 0.164
 Next step is calculation of WACC
 Given the cost of levered equity as 16.4%
 WACC = 7/11 * 16.4 + 4/11 * 12 (1 -0.3) = 10.44 + 3.05 = 13.49
Calculation of Terminal value of
Equity
 380 (1.10)/(0.1349- 0.10) /1.14^5
 418/0.0349 = 11977/1.93 = 6205.70
 Value of Equity=
 PV of FCFF for five years (Discounted at 14%) = 968.52
 PV of Interest tax shield (Discounted at 12%) = 41.88
 PV of Terminal value (discounted at 14%) = 6205.70 7216.10
Economic profit model

 Economic profit model is the surplus left after making appropriate

charge for the capital invested in the business. The EP of a single
period is : IC*(ROIC – WACC), IC being Invested Capital, ROIC being
Rate of Invested Capital.
 Since the ROIC is equal to NOPLAT(Net operating profit less adjusted
taxes)/IC the equation can be re-written as
 EP = NOPLAT – IC * WACC
 According to this model the value of a firm (V0) is equal to the current
invested capital (IC0) + Present value of future economic stream.
 Vo =IC0 + ICt-1(stream of cash flows) * (ROICt – WACC)/ (1+
WACC)^t
Illustration

 Global Limited has an invested capital of 50 million. Its return on

invested capital (ROIC) is 12 percent and its weighted average cost of
capital (WACC) is 11 percent. The expected growth rate in Global’s
invested capital will be 20 percent for the first three years, 12 percent
for the following two years, and 8 percent thereafter for ever.
Calculate forecast for the company in the following format:
 Year 1 2 3 4 5 6 7
 Invested capital 50
 ROIC(12%) 6
 Net investment 10 12 14.40 10.37 11.61 8.67
9.36
Free cash flow calculation

 FREE CASH FLOW

 Year 1 2 3 4 5 6
7
 Invested capital 50 60 72 86.40 96.77 108.38
117.05
 NOPLAT 6 7.20 8.64 10.37 11.61 13.01
14.05
 Cost of Capital 0.11 0.11 0.11 0.11 0.11 0.11
0.11
 Growth rate 0.20 0.20 0.20 0.12 0.12 0.08
0.08
 Net investment 10 12 14.40 10.37 11.61 8.67
9.36

Solution

 1 2 3 4 5 6
7
 Free cash flow (4.00) (4.80) (5.76) 0 0 4.34
4.69
 Calculate present value of Free cash flows (FCFF) for the planning
period.
 Then calculate the horizon value at the end of six years(seventh year
value) applying constant growth model.
 Calculate PV of this value.
 Adding PV of Free cash flows and present value of horizon value will
give
 Enterprise DCF value.
Solution

 -3.60 + -3.90 + - 4.21 +0 + 0 +2.32 (discounting by cost of capital

11%)
 PV FCF = -9.4 million
 4.69/0.11 -0.08/1.11^6 = 156.33/1.87
 PV horizon value = 83.6 million
 Enterprise DCF value = 74.1 million
Using ECONOMIC PROFIT approach

 Inv.Cap 50 60 72 86.40 96.77 108.38

117.05
 NOPLAT 6 7.20 8.64 10.37 11.61 13.00
14.05
 Cost of capital 11%
 Calculate Capital charge and Economic Profit.
ECONOMIC PROFIT

 INV*0.11 5.50 6.60 7.92 9.50 10.64 11.92

12.88
 EP 0.50 0.60 0.72 0.87 0.97 1.08
1.17
 Calculate Present value of EP stream and Add Initial invested capital
to get Enterprise value.
Solution

 Present value of EP for six years = 3.19 discounted at 11%

 Horizon value of final stream of seventh year = 39. PV = 20.85
 Present value of EP stream = 24 million
 (PV of six cash flow streams + Horizon value of Final stream)
 Value of Invested capital 50
 Total 74 million.