EF4312: Mergers and Acquisitions

EF4312: Mergers and Acquisitions

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Week 2: DCF Review

Ran Duan
ran.duan@cityu.edu.hk

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These lecture notes are developed based on Gregg Jarrell’s lecture notes for Cases in
Finance 2014 Winter at the University of Rochester’s Simon Business School. I learned
valuation from Gregg and very much enjoyed this class.
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 EF4312: Mergers and Acquisitions

Blueprint of DCF valuation and MVBS analysis

• Step 1: Perform DCF valuation to estimate Enterprise Value
• Step 2: Determine Cash and value of other non-operating assets
• Step 3: Add Cash to EV (from step 1) to estimate Total Asset Value
• Step 4: Find Total Liabilities Value which must equal Total Asset Value
(MVBS identity)
• Step 5: Determine Long-Term Debt, including Short-Term portion of LT
Debt payable within the year, plus other leases as well as liabilities including
environmental, legal, health-care, pension, the cost of which have not been
included in DCF analysis of EV
• Step 6: Subtract Debt and other Long-Term Liabilities from Total Liability
Value to infer Equity Value. In practice the Equity Value must be derived
from the DCF value of the Company’s Enterprise/Operating Assets
• Step 7: Determine the number of Shares Outstanding
• Step 8: Divide the Equity value by the shares outstanding to compute the
stock price

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DCF model for Enterprise Value

• Assumes that the present value of an enterprise is equal to the sum of

all future cash flows of the enterprise, discounted to the present value
at a discount rate (5-year forecast period):
   
N CF1 N CF2 N CF3 N CF4 N CF5 T V5
EV = + + + + +
1+r (1 + r)2 (1 + r)3 (1 + r)4 (1 + r)5 (1 + r)5

• where TV = Terminal Value at the end of the forecast period

N CF6
T V5 =
r−g
• Note that we use NCF at year 6 to compute TV at year 5

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Net Cash Flow (NCF)

• NCF stands for net cash flows, which are the projected cash revenues
(inflows) minus cash costs (outflows) attributed to the operating
assets (enterprise) of the company.
• NCF are often called “unlevered NCFs” because they do not deduct
any projected interest on LongTerm Debt or account for tax savings
from tax-deductible interest expense. Thus, NCF are cash flows
assuming the Company is unlevered (no Debt). This is because the
present-value of Debt is accounted for as a long-term liability on the
right side of the MVBS and tax savings are accounted for in the
weighted average capital of capital WACC.

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NCF and tax

• NCF does deduct taxes (usually assumed to be 40%), but these taxes
are calculated ignoring interest expense when computing NCF. That
is, NCF deducts taxes computed assuming that the Company has no
Debt and, therefore, no interest expense. Thus, if there are any
interest expenses, actual taxes will be less than appropriate
hypothetical taxes deducted when computing unlevered NCF.
• Because interest expenses are tax deductible, the tax-reducing
benefits of interest expenses are accounted for in calculating the
Weighted Average Cost of Capital, which uses the net-of-tax cost of
Debt capital.
• Because interest tax shields are accounted for in WACC, it would be
double-counting to also reduce taxes by deducting interest expenses
in computing NCFs. Thus, EBIT is treated as being 100% taxable
when computing NCF.

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Compute NCF

• Accounting EBIT equals Earnings Before deducting Interest and

Taxes.
• Accounting NOPAT = Accounting EBIT * (1 – Tax Rate)
• NOPAT stands for Net Operating Profit After Taxes
• Note that we compute NOPAT from EBIT assuming the company has
no debt, because tax savings from interest expense will be reflected in
Weighted Average Cost of Capital (WACC) which uses the net-of-tax
cost of debt
• Cash NOPAT = Accounting NOPAT - ∆WC
• ∆WC = R × ∆Sales
AR + IN V − AP
• R = Working Capital Ratio = Using historical data
Sales
for Accounts Receivable, Inventory, Accounts Payable, and Sales.

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Numerical example calculating change in working capital

• The sales projection this year for company A is $20 million, and sales
for last year were $4 million.
• Accounts Receivables were $1 million, Inventory was $1.5 million, and
Accounts Payable were $500,000, at the end of last year.
AR + IN V − AP
• R = Working Capital Ratio =
Sales
1 + 1.5 − 0.5
• R= = 0.5
4
• ∆WC = R × ∆Sales
• ∆WC = 0.5 × (20 − 4) = $8
• This investment in working capital is necessary to fuel the growth, so
we need to subtract this cash outflow from Accounting NOPAT in
order to get Cash NOPAT

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Compute NCF

• NCF = Cash NOPAT - (CAPX - DEP) = Cash NOPAT - CAPX +

DEP
• CAPX = Capital Expenditures
• DEP = Depreciation and Amortization
• (CAPX - DEP) is known as Net New Investment
• Depreciation reflects past CAPX expenditures for durable assets that
cannot be “expensed” in the year of the CAPX outlay. Rather, they
must be depreciated gradually over the “useful life” of the asset. In
computing NCF, we add back projected Depreciation, because it is a
“non-cash” expense.
• On the other hand, projected future CAPX is a cash outlay that must
be deducted when computing NCF.

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 EF4312: Mergers and Acquisitions

Compute NCF

• Practitioners usually assume EBIT equals Sales times Operating

Margin
• Operating Margin reflects a company’s profitability
• If Operating Margin = 0.4, EBIT = 0.4 * Sales
• To calculate NCF, we start from Sales, this is called the top-down
approach, the predominant method for DCF analysis

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Summary of NCF calculation

• Start from Sales (projected)

• Accounting EBIT = Sales * Operating Margin
• Accounting NOPAT = Accounting EBIT * (1 – Tax Rate)
• Cash NOPAT = Accounting NOPAT - ∆WC
• NCF = Cash NOPAT - CAPX + DEP

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DCF model spreadsheet

• NCF calculation for forecast period

Sales Input from forecast

EBIT = Sales * Operating Margin
Accounting NOPAT = EBIT * (1 - Tax Rate)
∆WC = ∆Sales * Working Capital Ratio
Cash NOPAT = Accounting NOPAT - ∆WC
CAPX Input from forecast
Depreciation Input from forecast
NCF = Cash NOPAT - CAPX + Depreciation

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 EF4312: Mergers and Acquisitions

DCF model spreadsheet

• NCF calculation for stable growth period (terminal value)

Sales6 = Sales5 * (1 + g)
EBIT = Sales6 * Operating Margin
Accounting NOPAT = EBIT * (1 - Tax Rate)
∆WC = ∆Sales6 * Working Capital Ratio
Cash NOPAT = Accounting NOPAT - ∆WC
CAPX
Depreciation
NCF = Cash NOPAT * (1 - plowback ratio)

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Compute discount rate (WACC)

• In DCF Analysis of Enterprise Value, Weighted Average Cost of

Capital (WACC) is the most widely-applied method of estimating the
risk-adjusted discount rate r used to discount Net Cash Flows to get
EV
r = WACC = WD RD (1 − T ) + WE RE

• WD = D/(D + E) is MV Debt divided by MV of Liabilities

• WE = E/(D + E) is MV Equity divided by MV of Liabilities
• RD is gross cost of long term debt capital (annual rate)
• T is Corporate tax rate
• RE is cost of equity capital (CAPM)
• Will use r and WACC interchangeably

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Capital Asset Pricing Model (CAPM)

RE = Rf + β × (Rm − Rf ) + Rsize

• Rf is the risk-free rate

• β is the company’s equity beta
• Rm is the equity market return, Rm − Rf is called equity market risk
premium
• Rsize is size-related add-on premium

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Numerical example of computing WACC

• Long-term Risk-Free Rate is 3.0%

• Company’s gross cost of debt capital is 6%
• Tax rate is 40
• Debt-to-value ratio is 0.3
• Equity Beta is 1.5
• Equity Risk Premium is 6.0%
• Size-Related Add-On Premium is 3.5%

RE = Rf + β × (Rm − Rf ) + Rsize = 0.03 + 1.5 × 0.06 + 0.035 = 15.5%

W ACC = WD RD (1−T )+WE RE = 0.3∗0.06∗0.6+0.7∗15.5% = 11.93%

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DCF model spreadsheet

• WACC calculation

Risk free rate Input from assumptions

Beta Input from assumptions
Risk premium Input from assumptions
Size premium Input from assumptions
Equity cost = Risk free rate + Beta * Risk premium + Size premium
Debt cost Input from assumptions
Debt weight Input from assumptions
Equity weight = 1 - Debt weight
WACC = Debt cost * Debt weight * (1 - Tax rate)
+ Equity cost * Equity weight

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Terminal Value (TV)

• TV is the continuing value of the company as of the end of the

Forecast Period and accounts for NCFs from that point in time
through Perpetuity.
• Common to assume that by the end of the Forecast Period the
Company has reached steady state equilibrium, thus permitting the
use of a constant-growth valuation model, which requires fewer
assumptions than Forecast Period projections.
• All assumptions made for computing the Terminal Value are very
important and should be defendable by analyst as most reasonable,
unbiased, best estimates for long-run, steady-state operation in
perpetuity. Terminal Value is often the predominate component of
DCF Enterprise Value, and its reasonableness is the responsibility of
the financial analyst.

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Compute TV

• Most rigorous approach is to base Terminal Value calculation on the

constant-growth perpetuity model:

N CF6
T V5 =
r−g
• N CF6 = Cash NOPAT6 ∗ (1 − k)
• k is known as plowback ratio
• Cash NOPAT6 = Sales5 ∗ (1 + g) ∗ Operating Margin ∗ (1 − T ) − ∆WC
• g is constant growth rate of sales and NCF from year 6 into perpetuity

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Summary of DCF

• Compute NCF from Sales in the forecast period

• Compute discount rate r = WACC (use CAPM for equity return)
• Compute sum of present value of NCFs in the forecast period
• Compute NCF in the year after the forecast period
• Compute TV (at the end of the forecast period)
• Compute present value of TV

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Review before we go over some examples

• WACC calculation

Risk free rate Input from assumptions

Beta Input from assumptions
Risk premium Input from assumptions
Size premium Input from assumptions
Equity cost = Risk free rate + Beta * Risk premium + Size premium
Debt cost Input from assumptions
Debt weight Input from assumptions
Equity weight = 1 - Debt weight
WACC = Debt cost * Debt weight * (1 - Tax rate)
+ Equity cost * Equity weight

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Review before we go over some examples

• NCF calculation for forecast period

Sales Input from forecast

EBIT = Sales * Operating Margin
Accounting NOPAT = EBIT * (1 - Tax Rate)
∆WC = ∆Sales * Working Capital Ratio
Cash NOPAT = Accounting NOPAT - ∆WC
CAPX Input from forecast
Depreciation Input from forecast
NCF = Cash NOPAT - CAPX + Depreciation

• Use WACC to discount the NCFs in the first five years and find sum
of PV of NCFs in the forecast period

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Review before we go over some examples

• NCF calculation for stable growth period (terminal value)

Sales6 = Sales5 * (1 + g)
EBIT = Sales6 * Operating Margin
Accounting NOPAT = EBIT * (1 - Tax Rate)
∆WC = ∆Sales6 * Working Capital Ratio
Cash NOPAT = Accounting NOPAT - ∆WC
CAPX
Depreciation
NCF = Cash NOPAT * (1 - plowback ratio)

• Use Gordon growth model to find out Terminal Value, and then use
WACC to discount TV to findout the PV of TV

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DCF example 1
We would like to value the following company:
• Sales forecast for 2021 is $20 million, and sales are projected to grow by 50% each
year in the forecast period through 2025. Sales growth in the perpetuity period is
projected to be 10% annually. Sales for 2020 were $4 million.
• EBIT margin is 70%. The tax rate is 40% in the forecast and perpetuity periods.
• Accounts Receivables were $1 million, Inventory was $1.5 million, and Accounts
Payable were $500,000, as of 12/31/2020
• CAPX is $10 million in 2021, and will increase by $5 million per year until 2025,
when CAPX will be $30 million. Depreciation will be $20 million in 2021, and will
increase by 20% annually throughout the forecast period.
• Cost of debt is 8% and debt over asset ratio (leverage) is 40%.
• Risk-free rate is 5%, risk premium is 8%, and size-related add-on premium is 4%.
Assume that beta is 1.81. Assume plowback ratio k is 0.2.
• Cash totals $89 million, and Long-Term Debt is $120 million, as of 12/31/20.
There are 30 million common shares outstanding. What is the stock price?

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DCF example 1 solution

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DCF example 2
We would like to value the following company:
• Sales for 2020 are $150 million, and sales are projected to be $200 million for 2021,
and to grow 50% annually through 2025 (last year in 5-year Forecast Period). After
that the company will enter stable growth period and sales will grow 8% annually.
• EBIT is projected to be 40% of sales in all years, and the tax rate is 40% for all
years.
• Net New Investment (NNI = CAPX - DEP) in the Forecast Period is expected to
be $30.
• Accounts Receivables are $20 million, Inventory is $40 million, and Accounts
Payable are $30 million, as of 12/31/2020.
• Assume that the risk free rate is 5%, the equity risk premium is 8%, the company’s
equity beta is 2.0 and the size-related add-on premium is 4%. Assume that the
before-tax cost of debt is 10% and leverage ratio is 50%. Assume plowback ratio k
= 0.2.
• The Company has $500 in cash, long-term debt of $752 million, and 40 million
shares of common stock outstanding. What is the stock price?

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DCF example 2 solution

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DCF in-class exercise

We would like to value the following company:
• Sales forecast for 2021 is $100 million, and sales are projected to grow by 50%
each year in the forecast period through 2025. Sales growth in the perpetuity
period is projected to be 6% annually. Sales for 2020 were $50 million.
• EBIT margin is 50%. The tax rate is 40% in the forecast and perpetuity periods.
• Accounts Receivables were $20 million, Inventory was $20 million, and Accounts
Payable were $15 million, as of 12/31/2020
• CAPX is $30 million in 2021, and will increase by $5 million per year until 2025.
Depreciation will be $30 million in 2021, and will increase by $5 million annually
throughout the forecast period.
• Cost of debt is 10% and debt over asset ratio (leverage) is 40%.
• Risk-free rate is 5%, risk premium is 7.5%, and size-related add-on premium is
3.5%. Assume that beta is 1.28. Assume plowback ratio k is 0.2.
• Cash totals $476 million, and Long-Term Debt is $500 million, as of 12/31/20.
There are 80 million common shares outstanding. What is the stock price?

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Apple valuation

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Depreciation tax shield

• EBIT = Sales - Depreciation - Other costs

• Accounting NOPAT = EBIT * (1 - T)
= Sales * (1 - T) - Depreciation * (1 - T) - Other costs * (1 - T)
• NCF = Accounting NOPAT - Inc WC - CAPX + Depreciation
= EBIT * (1 - T) - Inc WC - CAPX + Depreciation
= Sales * (1 - T) - Depreciation * (1 - T) - Other costs * (1 - T) - Inc WC - CAPX
+ Depreciation
= Sales * (1 - T) - Other costs * (1 - T) - Inc WC - CAPX + Depreciation * T
• The last term Depreciation * T is the depreciation tax shield.

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