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To sum up, valuing a firm using the discounted cash flow approach calls for
forecasting cash flows over an indefinite period of time for an entity that is
expected to grow. This is indeed a daunting proposition. To tackle this task, in
practice, the value of the firm is separated into two time periods:
Value of the firm = Present value of cash flow + Present value of cash flow
during an explicit forecast after the explicit forecast
period period
During the explicit forecast period which is often a period of 5 to 15 years
the firm is expected to evolve rather rapidly and hence a great deal of effort is
expended to forecast its cash flow on an annual basis. At the end of the
explicit forecast period, the firm is expected to reach a steady state and
hence a simplified procedure is used to estimate its continuing value
1 2 3
Equity capital 60 90 90
Reserves & surplus 40 49 61
Debt 100 119 134
Total 200 258 285
Fixed assets 150 175 190
Investment - 20 25
Net current assets 50 63 70
Total 200 258 285
If we assume that the investment figures of 20 and 25 in the balance sheet of Matrix
Limited at the end of years 2 and 3 represent excess cash and marketable securities,
the operating invested capital at the end of years 1, 2, and 3 for Matrix Limited is:
1 2 3
Operating invested 200 238 260
capital
The free cash flow (FCF) is the post-tax cash flow generated from the operations
of the firm after providing for investments in fixed investment and net working
capital required for the operations of the firm. FCF can be expressed as:
FCF = NOPLAT - Net investment
FCF = (NOPLAT + Depreciation) - (Net investment +
Depreciation)
FCF = Gross cash flow - Gross investment
Exhibit shows the FCF calculation for Matrix Limited
Matrix Limited Free Cash Flow
Year 1 Year 2 Year 3
NOPLAT 25.2 30.0 27.0
Depreciation 12 15 18
Gross cash flow 37.2 45 45
(Increase)/decrease in 13 7
working capital
Capital expenditure 40 33
Gross investment 53 40
Free cash flow (8) 5
Cash Flow Available To Investors
Growth rate
= Invested capital x ROIC x 1-
ROIC
Thus, invested capital, ROIC, and growth rate are the basic drivers of FCF. The
drivers of FCF for Matrix Limited for the years 2 and 3 are given below:
Year 2 Year 3
NOPLAT
ROIC = 15.00% 11.3 %
Invested capital
Net investment
Growth rate = 19.00% 9.2%
Invested capital
FCF -Rs.8 million Rs.5 million
Centre for Financial Management , Bangalore
Developing The ROIC Tree
As ROIC is a key driver of free cash flow and valuation, it is useful to develop the ROIC
tree which disaggregates ROIC into its key components. The starting point of the
ROIC tree is:
NOPLAT
ROIC =
Investment
Since NOPLAT is equal to EBIT times (1-cash tax rate), ROIC can be expressed as pre-
tax ROIC times (1-cash tax rate):
EBIT
ROIC = (1- Cash tax rate)
Invested capital
Pre-tax ROIC can be broken down into two components as follows:
EBIT EBIT Revenues
= x
Invested capital Revenues Invested capital
Operating Capital
Margin turnover
The first term, viz, operating margin measures how effectively the firm converts
revenues into profits and the second term, viz, capital turnover reflects how
effectively the company employs its invested capital. Each of these two components
Matrix Limited ROIC Tree for Year 3
Tax on EBIT
Tax provision on income statement 26 32
+ Tax shield on interest expense 9.6 11.2
- Tax on interest income (4) (6)
- Tax on non-operating income (2) (4)
Tax on EBIT 29.6 33.2
Interest Coverage
EBITDA/Interest
Leverage
ROE = ROIC + [ROIC r (1-t) ] D/E
Dividend Payout
General Guidelines for Historical Analysis
Reserves and surplus (t+1) = Reserves and surplus (t) + Profit after tax (t+1) -Dividends (t+1)
in million
4 5 6 7 8
Equity capital 90 90 90 90 90
Reserves &
75 88 105 127 151
surplus
Debt 140 150 161 177 192
Total 305 328 356 394 433
Fixed assets 220 240 266 294 324
Investments 10 - - - -
Net current
75 88 90 100 109
assets
Total 305 328 356 394 433
Step 5 : Calculate FCF and ROIC
in million
4 5 6 7 8
2. Interest expense 18 20 21 23 25
3. Interest income 3 2 - - -
4. Non-operating income - - - - -
B. TAXES ON EBIT : (5) + (6) - (7) - (8) 19.0 23.2 26.4 28.2 28.0
E: FREE CASH FLOW: (C) - (D) 3.0 5.8 16.6 13.8 16.0
Present value of cash flow during + Present value of cash flow the explicit forecast
period after the explicit forecast period
The second term represents the continuing value or the terminal value. It is the value
of the free cash flow beyond the explicit forecast period. Typically, the terminal value is
the dominant component in a companys value. Hence, it should be estimated carefully
and realistically.
Market-to-book ratio
method
where CVT is the continuing value at the end of year T, FCFT+1 is the expected
free cash flow for the first year after the explicit forecast period, WACC is the
weighted average cost of capital, and g is the expected growth rate of free
cash flow forever.
This method too uses the growing free cash flow perpetuity formula but
expresses it in terms of value drivers as follows:
NOPLATT+1 (1 g / r)
CVT =
WACC g
where CVT is the continuing value at the end of year T, NOPLATT+1 is the
expected net operating profits less adjusted tax for the first year after the
explicit forecast period, WACC is the weighted average cost of capital, g is the
constant growth rate of NOPLAT after the explicit forecast period, and r is the
expected rate of return on net new investment.
The formulae given in Eqns (32.2) and (32.3) produce the same result as they
have the same denominator, and the numerator in Eqn (32.3) is a different way
of expressing the free cash flow (the numerator of Eqn (32.2).
ROIC
12% 14% 16% 18%
G
R 6% 8333 9524 10417 11111
O
W
T
8% 8333 10714 12500 13889
H
R
A
T
E 10% 8333 14286 18750 22222
Some Misconceptions about Continuing Value
Year 8
Multiples method
Replacement cost method
Liquidation value method
Multiples Method
FCF9 FCF8 (1 + g)
Continuing value8 = =
WACC - g WACC - g
16 (1.10)
= = Rs.440 million
0.14 - 0.10
440
PV (CV) = = 228.52
(1.14)5
Value of operations = 34.77 + 228.52
= 263.29 million
Calculate the Enterprise Value and Value of
Equity
To the value of operations you have to add the value of
non-operating assets to get the enterprise value.
From the enterprise value, you have to deduct the
value of non-equity claims to get the equity value.
Thus:
Enterprise value = Value of operations + Value of non-operating
assets
Equity value = Enterprise value Value of non-equity claims
Potential
Entrants
Threat of
New Entrants
Substitutes
Customer Segmentation Analysis
Organisational
Fitness Strategy Financial Tool Structure
Landscape
Stable Short jumps DCF Centralised
396.1 1
PV (TV) = x = 2188.23
0.15 - 0.06 (1.15)5
FIRM VALUE = 397.44 + 2188.23 = 2585.67 M
Centre for Financial Management , Bangalore
The three- stage growth model may be illustrated with an example. Multiform
Limited is being appraised by an investment banker . The following information
has been assembled
Base Year (Year 0) Information
Revenues = Rs.1000 million
EBIT = Rs.250 million
Capital expenditure = Rs.295 million
Depreciation and amortisation = Rs.240 million
Working capital as a percentage of revenues = 20 percent
Tax rate = 40 percent( for all time to come)
Inputs for the High Growth Period
Length of the high growth period = 5 years
Growth rate in revenues, depreciation, = 25 percent
EBIT, and capital expenditures
Working capital as a percentage of revenues = 20 percent
Cost of debt = 15 percent (pre-tax)
Debt-equity ratio = 1.5
Risk free rate = 12 percent
Market risk premium = 6 percent
Equity beta = 1.583
WACC= 0.4 [12 + 1.583(6)] + 0.6 [15(1-0.4)] = 14.00 percent
Centre for Financial Management , Bangalore
Inputs for the Transition Period
Length of the transition period = 5 years
Growth rate in EBIT will decline from 25 percent
in year 5 to 10 percent in year 10 in linear move-
ments of 3 percent each year
Working capital as a percentage of revenues = 20 percent
The debt-equity ratio during this period will drop
to 1:1 and the pre-tax cost of debt will be
14 percent
Risk - free rate = 11 percent
Market risk premium = 6 percent
Equity beta = 1.10
WACC = 0.5 [11 + 1.1(6)] +0.5 [14 (1-0.4)]
= 13.00 percent