Forecasting and Valuing Cash Flows

Question 1

Three-Step DCF Process: Step 1

Answer 1

Step 1: Forecast the amount and timing of future cash flows.

Question 2

Three-Step DCF Process: Step 2

Answer 2

Step 2: Estimate a risk-appropriate discount rate. Combine the debt and equity discount rates (weighted average cost of capital, or WACC).

Question 3

Three-Step DCF Process: Step 3

Answer 3

Discount the cash flows using WACC to estimate the value of the project as a whole.

Question 4

Calculation of Free Cash Flow (FCF)

Answer 4

EBIT * (1 - Tax Rate) + Depreciation Expense - Capital Expenditure - Change in Operating NWC

Question 5

Accrual accounting

Answer 5

Designed to match expenses with revenues.

Question 6

What cash flows are relevant to the valuation of a project or investment?

Answer 6

Only the incremental cash flows are relevant. (Consider the cannibalization of revenues when a new product is launched).

Question 7

Project Valuation: Project FCF

Answer 7

Discussing project related valuation: FCF available for distribution to the various claimants (debt and equity holders) after funding any new projects.

Question 8

Business valuation: Firm FCF

Answer 8

Discussing business valuation: FCF available for distribution to the various claimants (debt and equity holders) after paying all the firm expenses.

Question 9

Equity FCF

Answer 9

Amount of cash flow that is available for distribution to the firm’s equity holders. (FCF - Sum of After-Tax Interest paid to firm’s creditors + Net new debt)

Question 10

NOPAT

Answer 10

Net Operating profit after taxes or EBIT * (1 - Tax Rate)

Question 11

Computation of FCF: EBIT

Answer 11

Compute the tax liability on EBIT (Earnings before interest and taxes) because we are computing the cash flow that will be available for payment to all the firm’s sources of financing, including both its creditors (who receive principal plus interest) and equity investors.

Question 12

Price Decay

Answer 12

Commonly used to forecast prices of high-tech products (understanding that as time goes on, price of tech products tend to decrease)

Question 13

Experience curve/Learning curve model

Answer 13

When the cumulative market volume doubles, or advances, there is a lower associated cost with the production of a product.

Question 14

Salvage value

Answer 14

Final cash flow when valuing specifically, individual projects that have a finite life.

Question 15

Terminal value

Answer 15

Used when productive life of the project assets is expected to continue indefinitely, represents the present value of all investment cash flows beyond the end of the analysis period.

Question 16

Net present value

Answer 16

Difference between the present value of the project’s expected future cash flows and the initial cost of investment.

Question 17

Internal rate of return

Answer 17

Compound rate of return earned on the investment when NPV = 0.

Investment outlay = sum of FCFt/(1 + IRR)^t

Question 18

Project intrinsic value

Answer 18

Sum of the present values of annual FCFs

Question 19

if IRR > NPV

Answer 19

Invest!

Question 20

If NPV > 0

Answer 20

Invest!

Question 21

Mutually exclusive investment

Answer 21

Requires consideration of multiple alternatives or competing projects.

Question 22

Gordon growth formula

Answer 22

PV = C / (r - g), where r > g.

g = growth rate
r = discount rate
C = cash flow

Question 23

Capex

Answer 23

Net PPE for 2015 - Net PPE for 2014 + Depreciation expense

Question 24

Changes in operating net working capital

Answer 24

(Operating net working capital)t - (Operating net working capital)t-1

Question 25

Why do we use change in operating net working capital rather than increase because

Answer 25

the change can be either positive or negative. failure to consider need for additional working capital results in an overestimate of the value of the investment.

Question 26

PV of annual payments

Answer 26

Payment * (1 - (1-r)^-n)/r