introduction to discounted cash flow valuation nicholas ramm finance sector, madison investment fund...
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Introduction to Introduction to Discounted Cash Flow Discounted Cash Flow
ValuationValuation
Nicholas RammNicholas Ramm
Finance Sector, Madison Investment Finance Sector, Madison Investment FundFund
October 29, 2007October 29, 2007
What is DCF analysis?What is DCF analysis?
Method of valuing a financial assetMethod of valuing a financial asset Focus on firmsFocus on firms
Uses Uses cash flowscash flows
Find Find present valuepresent value of these cash of these cash flowsflows
Present ValuePresent Value
Value of future money todayValue of future money today
PV=FV
(1+R)T
The Concept-Part 1The Concept-Part 1
Firm Value = $1 + $2 + $3 + $4 + $5 + …(1+R)1 (1+R)2 (1+R)3 (1+R)4 (1+R)5
Cash Flow
Discount Rate Need CFs forever
Free Cash FlowFree Cash Flow
Measure of money available to investorsMeasure of money available to investors FCF = (Net Inc.) +FCF = (Net Inc.) +
(Depreciation/Amortization) -(Depreciation/Amortization) -
(CapEx) -(CapEx) -
(Increase in Working Capital) +(Increase in Working Capital) +
(Misc. firm-specific items)(Misc. firm-specific items) All items available in financial All items available in financial
statementsstatements
ForecastingForecasting
Inherently subjectiveInherently subjective
Choose a forecast period and a Choose a forecast period and a method to generate FCFsmethod to generate FCFs Percentage of sales, Construct new Percentage of sales, Construct new
financial statementsfinancial statements
The Concept-Part 2The Concept-Part 2
Firm Value = FCF1 + FCF2 + FCF3 + FCF4 + FCF5 + …(1+R)1 (1+R)2 (1+R)3 (1+R)4 (1+R)5
Discount Rate Need CFs forever
Terminal YearTerminal Year
Can’t forecast foreverCan’t forecast forever
Assume company stabilizes Assume company stabilizes
Grows at G foreverGrows at G forever
Terminal YearTerminal Year
TYV = FCFTY * (1 + G)
R - G
The Concept-Part 3The Concept-Part 3
Firm Value = FCF1 + FCF2 + FCF3 + FCF4 + FCF5 +…+ TYV(1+R)1 (1+R)2 (1+R)3 (1+R)4 (1+R)5 (1+R)TY
Discount Rate
Discount RateDiscount Rate
Cash Flows and Terminal Year Value Cash Flows and Terminal Year Value must be discountedmust be discounted
Need rate that takes into account Need rate that takes into account relative risks of businessrelative risks of business
Weighted Average Cost of CapitalWeighted Average Cost of Capital
R* = RE *E
D+E + RD *D
D+E
Obtain Using CAPM Weighted Average Debt interest rate
* (1-t)
Capital Asset Pricing ModelCapital Asset Pricing Model
RE = RF + β * (Rm – Rf)
Putting it All TogetherPutting it All Together
Firm Value = FCF1 + FCF2 + FCF3 + FCF4 + FCF5 + …+ TYV
(1+R*)1 (1+R*)2 (1+R*)3 (1+R*)4 (1+R*)5 (1+R*)TY
LimitationsLimitations
Forecasting error:Forecasting error: Future cash flowsFuture cash flows Future capital structureFuture capital structure Terminal growth rateTerminal growth rate
Assume unchanging firmAssume unchanging firm Capital StructureCapital Structure Terminal growth rateTerminal growth rate
Questions?Questions?
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