Forecasting and Valuing Cash Flows Flashcards
Three-Step DCF Process: Step 1
Step 1: Forecast the amount and timing of future cash flows.
Three-Step DCF Process: Step 2
Step 2: Estimate a risk-appropriate discount rate. Combine the debt and equity discount rates (weighted average cost of capital, or WACC).
Three-Step DCF Process: Step 3
Discount the cash flows using WACC to estimate the value of the project as a whole.
Calculation of Free Cash Flow (FCF)
EBIT * (1 - Tax Rate) + Depreciation Expense - Capital Expenditure - Change in Operating NWC
Accrual accounting
Designed to match expenses with revenues.
What cash flows are relevant to the valuation of a project or investment?
Only the incremental cash flows are relevant. (Consider the cannibalization of revenues when a new product is launched).
Project Valuation: Project FCF
Discussing project related valuation: FCF available for distribution to the various claimants (debt and equity holders) after funding any new projects.
Business valuation: Firm FCF
Discussing business valuation: FCF available for distribution to the various claimants (debt and equity holders) after paying all the firm expenses.
Equity FCF
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)
NOPAT
Net Operating profit after taxes or EBIT * (1 - Tax Rate)
Computation of FCF: EBIT
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.
Price Decay
Commonly used to forecast prices of high-tech products (understanding that as time goes on, price of tech products tend to decrease)
Experience curve/Learning curve model
When the cumulative market volume doubles, or advances, there is a lower associated cost with the production of a product.
Salvage value
Final cash flow when valuing specifically, individual projects that have a finite life.
Terminal value
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.
Net present value
Difference between the present value of the project’s expected future cash flows and the initial cost of investment.
Internal rate of return
Compound rate of return earned on the investment when NPV = 0.
Investment outlay = sum of FCFt/(1 + IRR)^t
Project intrinsic value
Sum of the present values of annual FCFs
if IRR > NPV
Invest!
If NPV > 0
Invest!
Mutually exclusive investment
Requires consideration of multiple alternatives or competing projects.
Gordon growth formula
PV = C / (r - g), where r > g.
g = growth rate r = discount rate C = cash flow
Capex
Net PPE for 2015 - Net PPE for 2014 + Depreciation expense
Changes in operating net working capital
(Operating net working capital)t - (Operating net working capital)t-1
Why do we use change in operating net working capital rather than increase because
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.
PV of annual payments
Payment * (1 - (1-r)^-n)/r
