Business Analysis and Valuation

Dr. Aprajita Pandey

BITS Pilani Department of Economics and Finance
Pilani Campus
 BITS Pilani
Pilani Campus

Lecture No.17
Forecasting and Valuing Cash Flows
 Discounted Cash Flows

• The idea behind discounted cash flow (DCF) valuation analysis is

simple: The value of an investment is determined by the magnitude and
the timing of the cash flows it is expected to generate. The DCF
valuation approach provides a basis for assessing the value of these
cash flows and consequently is a cornerstone of financial analysis.

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 The Three Step DCF Process

• Forecast the amount and timing of future cash flows – Forecast project free cash
flow
• “How much cash is the project expected to generate and when?”
• Estimate a risk-appropriate discount rate- Combine the debt and equity discount rate
(weighted average cost of capital, WACC)
• “ How risky are the future cash flows, and what do investors currently expect to receive for investments of similar risk?”
• Discount the cash flows- Discount PFCF using WACC to estimate the value of the
project as a whole.
• What is the present value ‘equivalent of the investment’s expected future cash flows?”

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 Defining Investment Cash Flows

• Arriving at an estimate of the value of an investment using DCF analysis requires

that the analyst have a good understanding of the investment’s cash flows. Three key
issues related to the proper definition of investment cash flows:
• What cash flows are relevant to the valuation of a project or investment?
• Are the cash flow forecasts either conservative or optimistic?
• What is the difference between equity and project cash flows?

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 Relevant Cash Flows

• The relevant cash flows are often referred to as incremental cash flows since they are
the additional cash flows to the firm that are generated by the investment.
• These include the cash flows directly generated by the investment as well as the
indirect effects that the investment may have on a firm’s other lines of business.
• Sunk costs- A common mistake in the calculation of incremental cash flows.
• Sunk costs are expenditures that either have already been made or must be made
regardless of whether the firm proceeds with the investment. As a result, sunk costs
are not incremental costs and should thus be ignored in the investment analysis.

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 Conservative and Optimistic Cash Flows

• When academics talk about valuing an investment by discounting cash flows, they
generally assume that the cash flows represent “expected cash flows.”
• In statistical sense, they assume that managers estimate the cash flows that the firm
expects to realize in various scenarios and sum these cash flows after weighting them
by their probabilities of occurrence.
• In theory, the firm should discount these expected cash flows, using a risk-adjusted
rate of interest that reflects the risk of the cash flows.
• In practice, however, the cash flow forecasts that managers use are frequently not the
same as the expected cash flows that academics describe in their theories.

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 Conservative and Optimistic Cash Flows

• Depending on the situation, the cash flow forecasts of managers may be either too
conservative or too aggressive. Sometimes these biases exist because of managerial
incentives and at other times optimistic biases arise because of managerial
overconfidence.

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 Equity Versus Project Free Cash Flow

• Analysts typically structure their analysis of investment cash flows using projected
financial statements, commonly referred to as pro forma statements, for the project
or firm being valued.
• They develop their cash flow analysis by first projecting the income or earnings
consequences of the project and then using this information to calculate the project’s
cash flows.
• Equity free cash flow (EFCF) focuses on the cash flow that is available for
distribution to the firm’s common shareholders. Consequently, EFCF is used to value
the equity claim in the project.

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• The second cash flow definition is project-free cash flow (PFCF). This definition
combines the cash flows available for distribution to both the firm’s creditors and
equity holders. PFCF becomes the basis for estimating the value of the project as a
whole.

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 Equity Free Cash Flow (EFCF) for an all-
Equity Financed Project
• The Cash flow equals the amount of cash left over after paying all expenses,
including any additional investments in the project. The firm, then, can distribute the
remaining cash since it does not, by definition, need it. Consequently, our cash flow
calculations result in an cash flow figure that is free of any encumbrances or
commitments and can be distributed to the sources of capital used to finance the
investment.
• EFCF represents the cash produced by the project that can be distributed to equity
shareholders. Distributions can take the form of cash dividends or share repurchases.
• EFCE = EBIT (1-T) + DA- WC -CAPEX

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• Depreciation
First we subtract them in calculating taxable income, and then we add them back to
after-tax income to calculate cash flow.
• CAPEX
Can be calculated how net PPE changes on the balance sheet over time
Eg; consider the change in net PPE from 2006 to 2007
Net PPE (2006)
Less: Depreciation expense for 2007
Plus: CAPEX for 2007
Equals: Net PPE (2007)
CAPEX (2007) = Net PPE (2007) – Net PPE(2006) + Depreciation Expense for 2007

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• Changes in net working capital
Operating net working capital = [(CA) – (CL)]
Change in operating Net working capital = (operating net working capital)t –(operating
net working capital) t-1

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Example

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• Temporary Solutions Company wants to develop a new bathroom shower that has all
necessary features for upmarket luxury lifestyle. It expects that it can sell 2000 such
showers per year at a price of $125 each (while each can only costs $50 to produce).
Given the fads tend to come and go quickly, this product has a four-year useful life.
To produce this shower, they will need to purchase $120,000 in manufacturing
equipment, which will straight-line depreciate to zero after four years. Fixed costs of
the project, such as rent and utility bills are $20,000 per year. Temporary Solutions
Company will need to invest $25,000 in NWC, and the tax rate is 20%.

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 JC Crawford Enterprises
Estimating EFCFs for an All-Equity-Financed Project
Pro Forma Income statements
Income Statement ($000) 2007 2008 2009 2010 2011
Sales $1,000 $1,100 $1,210 $1,331 $1,464.10
Cost of goods sold -700 -770 -847 -931.7 -1024.87
Gross Profit 300 330 363 399.3 439.23
Operating expenses before dep -200 -220 -242 -266.2 -292.82
Depreciation Expense -40 -44 -48.4 -53.24 -58.56
EBIT 60 66 72.6 79.86 87.85
Interest Expense 0 0 0 0 0
Earnings before taxes 60 66 72.6 79.86 87.85
Taxes -18 -19.8 -21.78 -23.96 -26.35
Net Income $42 $46.20 $50.82 $55.90 $61.49

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 JC Crawford Enterprises (EFCFs)

Equity Free Cash Flows

EFCF($000) 2006 2007 2008 2009 2010 2011
Net Income $42 $46.20 $50.82 $55.90 $61.49
Plus: Depreciation and
Amortization 40 44 48.4 53.24 58.56
Less: Capital Expenditures -400 -40 -44 -48.4 -53.24 341.44
Less: Changes in net working
capital -150 -15 -16.5 -18.15 -19.97 219.62
Less: Principal Payments 0 0 0 0 0 0
Plus: Proceeds from new debt
issues 0 0 0 0 0 0
Equals: Equity Free Cash Flow ($550) $27 $29.70 $32.67 $35.94 $681.11

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Equity Free Cash Flow (EFCF) For a Levered
Project
• When a firm uses debt to partially finance its investments, there are two cash flow
consequences. First, when the debt is issued, there is a cash inflow equal to the net
proceeds from the issue. Second, the firm must make cash outlays for the principal
and interest payments throughout the life of the loan. Since interest expense is tax
deductible, it reduces the taxes the firm has to pay.
• We can calculate EFCF for a levered project as follows:
• EFCF = (EBIT – I) (1-T) + DA – CAPEX – WC – P + NP

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Where,
(EBIT – I) (1-T) Net income after taxes
EBIT Earnings before interest and taxes
EBIT (1-T) After-tax operating income or net operating profit after tax (NOPAT)
T Tax rate
DA Depreciation and amortization expense
WC Change in net working capital
CAPEX capital expenditures for property, plant and equipment
P principal payments on the firm’s outstanding debt
NP Net proceeds from the issuance of new debt

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 JC Crawford Enterprises
Estimating EFCFs for a Levered Project
Pro Forma Income statements
Income Statement ($000) 2007 2008 2009 2010 2011
Sales $1,000 $1,100 $1,210 $1,331 $1,464.10
Cost of goods sold -700 -770 -847 -931.7 -1024.87
Gross Profit 300 330 363 399.3 439.23
Operating expenses before dep -200 -220 -242 -266.2 -292.82
Depreciation Expense -40 -44 -48.4 -53.24 -58.56
EBIT 60 66 72.6 79.86 87.85
Interest Expense -22 -22.6 -23.26 -23.99 -24.78
Earnings before taxes 38 43.4 49.34 55.87 63.06
Taxes -11.4 -13.02 -14.8 -16.76 -18.92
Net Income $27 $30.38 $34.54 $39.11 $44.14

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 JC Crawford Enterprises (EFCFs)

Equity Free Cash Flows

EFCF($000) 2006 2007 2008 2009 2010 2011
Net Income $26.60 $30.38 $34.54 $39.11 $44.14
Plus: Depreciation and
Amortization 40 44 48.4 53.24 58.56
Less: Capital Expenditures -400 -40 -44 -48.4 -53.24 341.44
Less: Changes in net working
capital -150 -15 -16.5 -18.15 -19.97 219.62
Less: Principal Payments 0 0 0 0 0 -224.42
Plus: Proceeds from new debt
issues 220 6.00 6.60 7.26 7.99 0
Equals: Equity Free Cash $439.4
Flow ($330) $17.60 $20.48 $23.65 $27.13 2

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 Financial Leverage and the Volatility of
EFCFs
• When a firm borrows a portion of the funds it uses to finance an investment, we say
that it has employed financial leverage. The notion of leverage comes from the fact
that borrowing costs are generally fixed. As the firm’s profits rise and fall, the
borrowing costs do not change, which means that all of the risk associated with the
uncertain cash flows must be absorbed by the equity holders. This in turn, implies
that the shareholders’ cash flows become more volatile with the use of financial
leverage. To see this, compare the growth of EFCs of the JC Crawford Enterprise
investment for 2007 and 2010.
Unlevered Equity ($000)
2007 2010 Percent Change
EBIT $60.00 $79.86 33.1%
EFCF 27.00 35.94 33.1%
Levered Equity ($000)
2007 2010 Percent Change
EBIT $60.00 $79.86 33.1%
EFCF 17.60 27.13 54.1% BITS Pilani, Pilani Campus
 Financial Leverage and the Volatility of
EFCFs

• This added volatility in EFCF is a direct result of the fact that the creditor return is
fixed. Thus, as the project’s EBIT grows larger, a larger fraction of the higher EBIT
goes to the firm’s shareholders.
• The effect of financial leverage, then, is to reduce the required investment by equity
holders and, at the same time, increase the risk of the shareholder’s investment.
Because of the higher risk, shareholders require higher rates of return to entice them
to invest in levered projects, other things remaining constant.

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 Project Free Cash Flow

• The more common definition of cash flow for purposes of evaluating investment
opportunities focuses on the cash flow available from the project that can be
distributed to both creditors and owners. We refer to this notion of cash flow as
project-free cash flow (PFCF).

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 Calculating PFCF

• Project Free Cash Flow (PFCF) combines the cash flow available for distribution to
all the firm’s sources of capital. We can calculate PFCF in one of two equivalent
ways. The first involves summing the cash flows that accrue to each of the project’s
claim holders (debt and equity), as we see in the following formula:
• Common stockholders (EFCF) NOPAT+DA-I(1-T)-P+NP-WC-CAPEX
• Creditors (net of tax savings) I(1-T)+P-NP
• Sum: Project free cash flow (PFCF) = NOPAT + DA – WC – CAPEX

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• NOPAT Net operating profit after taxes = EBIT(1-T)
• EBIT -Earnings before interest and taxes
• T- tax rate
• DA- Depreciation and amortization expense
• I- Interest expense
• P- Principal payments on outstanding debt
• NP- Net proceeds from newly issued debt
• WC-Change in net working capital
• CAPEX- Capital expenditures

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 Calculation of Project Free Cash Flow

Calculation of Project Free Cash Flow

Revenues
Less Cost of goods sold
Equals Gross Profit
Less Operating expenses (excluding depreciation and amortization
expense)
Equals Earnings before interest, taxes, depreciation and
amortization(EBITDA)
Less Depreciation and Amortization (DA)
Equals Earnings before Interest and taxes (EBIT)
Less Taxes
Equals Net operating profit after taxes (NOPAT)
Plus Depreciation and Amortization (DA)
Less Capital Expenditures (CAPEX)
Less Increases in net working capital (WC)
Equals Project free cash flows
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 Estimating PFCFs
Calculation of PFCFs-Direct Method
$0 2006 2007 2008 2009 2010 2011
EBIT $60.00 $66.00 $72.60 $79.86 $87.85
Less: Taxes -18.00 -19.80 -21.78 -23.96 -26.35
NOPAT $42.00 $46.20 $50.82 $55.90 $61.49
Plus: Depreciation expense 40.00 44.00 48.40 53.24 58.56
Less: Capital Expenditures(CAPEX) -400.00 -40.00 -44.00 -48.40 -53.24 341.44
Less: Changes in WC -150 -15.00 -16.50 -18.15 -19.97 219.62
Equals: Project free cash flow (PFCF) ($550) $27.00 $29.70 $32.67 $35.94 $681.11

Calculation of PFCFs-IN Direct Method

2006 2007 2008 2009 2010 2011
Equity free cash flow ($330) $17.60 $20.48 $23.65 $27.13 $439.34
Plus: Interest (1-T) 15.4 15.82 16.28 16.79 17.35
Plus: Principal payments 224.42
Less: New debt issues -220 -6 -6.6 -7.26 -7.99
Equals: Project free cash flow (PFCF) ($550) $27.00 $29.70 $32.67 $35.94 $681.11

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