CHAPTER 5

DISCOUNTED CASH
FLOWS METHOD
DISCOUNTED CASH FLOWS METHOD
Discounted Cash flows analysis can be done by determining the
present value of the net cash flows of the investment property
opportunity.

In Conceptual Framework and Accounting Standards, the cash

flows are presented and analyzed based on their sources and activities
which are categorized operating, investing and financing.

In determining the value of an asset, it is essential to include

amount of cash that will be available for the claims of the equity owners.
NET CASH FLOWS

■ It refers to the amount of cash available for distribution to both debt and
equity claims of the business or asset.
■ This is calculated from the net cash generated from operations and for
investment over time.
■ For GCBO, the net cash flows generated will be based on the cash flows
from operating and investing activities, since this represents already the
amount earned or will be earned from this business and the amount that
is required to be infused in the operations to generate more profit.
Net Cash Flows is preferred as basis of valuation if any
of the following conditions are present:

■ Company does not pay dividends

■ Company pays dividends but the amount paid out significantly differs
from its capacity to pay dividends
■ Net Cash Flows and profits are aligned within a reasonable forecast
period
■ Investor has a control perspective. If an investor can exert control over a
company, dividends can be adjusted based on the decision of the
controlling investor.
Using net cash flows over other cash flow concepts is more advantageous in
a valuation activity since this metric can be directly used as an input to a
DCF model. This is not the case for other cash flow or earnings measures
such as EBITDA, EBIT, net income, and cash flow from operations since
these metrics might have missed or double-counted an item.

■ EBITDA and EBIT are both metrics that are before taxes; cash flows that
are available to investors should be after satisfying the tax requirements
of the government.
■ EBITDA and EBIT also do not consider differences in capital structure
since it does not capture interest payments, dividends for preference
shares, and funds sourced from bondholders to fund additional
investments.
■ All these measures also do not consider reinvestment of cash flows made
into the firm for additional working capital and fixed assets investment
In valuation, analysts find analyzing cash flows and its sources helpful in
understanding the following:
■ Source of financing for needed investments – Are investments internally
funded by cash generated from operations or debt/equity financing is
necessary? The best case for firms is to fund its investments wholly or
partly through cash from operations. Heavy reliance on external
financing from lenders or shareholders may signal that cash from
operations is not enough to support the firm’s long-term stability.
■ Reliance on debt financing – Debt financing is an excellent financing
strategy especially for expanding companies. However, it can become a
problem for a firm if its cash from operations is insufficient to repay
existing debt obligations. The situation worsens if firms continuously
refinance borrowings that come due by another borrowing.
■ Quality of earnings – Significant disparities between cash flows and
income may indicate earnings does not get converted to cash easily,
suggesting low quality.
TWO LEVELS OF NET CASH FLOWS

1. NET CASH FLOWS TO THE FIRM – is the amount made available

to both debt and equity claims against the company.

2. NET CASH FLOWS TO EQUITY – represents the amount of cash

flows made available to the equity stockholders after deducting the net
debt or the outstanding liabilities to the creditors less available cash
balance of the company.

*The net cash flows can be determined by referring to the financial

statements of the company.
NET CASH FLOWS TO THE FIRM
Net cash flow to the firm refers to the cash flow available to the parties who
supplied capital (i.e. lenders and shareholders) after paying all operating
expenses, including taxes, and investing in capital expenditures and
working capital as required by business needs. NCF to the firm is cash
flows generated from operating activities of the business which is intended
to pay required return of fund providers. Valuation models based on
enterprise value encompass cash flows available to all investors – whether
debt or equity.
Enterprise value of a company refers to the theoretical value of its core
business activities reflected by its net cash flows. This the basic premise of
most corporate valuation methodologies.

Net cash flow only capture items that are directly related to the operating
and investing activities of the business. Consequently, net cash flows
excludes items associated with financing activities. Net cash flows to the
firm can be computed or derived using the following approaches.
A. Based from Net Income (or Indirect Approach)

Net Income Available to Common shareholders Php xxx

Add: Non Cash Charges (net) xxx
Add: Interest Expense (net of Taxes) xxx
Add/Less: Adjustment in Working Capital xxx
Less: Net Investment in Fixed Capital xxx
(Purchases – Sales of Fixed Capital Investment)
Net Cash Flows to the Firm Php xxx
■ Net Income Available to Common Shareholders.

Basic measure of a firm’s profitability which refers to the bottom line

figure in an income statement. This is the amount left for the common
shareholders after deducting all costs, expenses, depreciation, amortization,
interest, taxes and dividends to preferred shareholders. This is an
accounting measure, meaning that non-cash items like depreciation and
amortization is also included as a deduction to arrive at a net income.
However, this measure does not include changes in working capital nor
capital investments made during the specific period which significantly
affects a firm’s cash flows.
■ Non-Cash Charges (Net).

Pertains to non-cash items that are included in the computation of net

income. Analyst usually look at the statement of cash flows to validate
potential non-cash charges. If amount in the income statement does not
match amount reflected in the cash flows statement, it can be indicative that
a portion of that expense is non-cash.
The common non-cash items are the following:

o Depreciation and amortization

When a firm acquires a fixed asset like equipment or intangible
asset, the initial cash outflow is made at point of acquisition and is
presented in the balance sheet. In succeeding periods, a portion of the
initial cash outflow is recorded as depreciation and amortization
which reduces net income, despite not having an actual cash outflow.
As a result, this should be added back to arrive at the real cash flow.
o Restructuring charges
Restructuring refers to the change in the organizational structure or
business model of a company adapt to changing economic climate or
business needs. Most restructuring involves involuntary separation
of employees. As a result, the restructuring requires the company to
pay them severance pay. Severance pay should comply with the
minimum requirements set in the Labor Code of the Philippines.
Severance pays are normally outright cashflows.

The company may also need to record write-down in value of

pension assets (or reversal of previous accruals) as a result of the
restructuring activity. This is usually recorded as part of the
restructuring expenses (income) in the income statement. However,
since there are no cash outlays involved in write-downs (reversal
gains), this should be added back to (deducted from) net income to
o Provisions for Doubtful Accounts
These are estimated amount to be incurred for the customers
inability to pay on time which is cumulatively accounted under the
statement of financial position reported against the accounts
receivable. Since these amounts represent the value that may have
high probability of collection but not yet written off, meaning there is
a positive chance that it can still be collected then it should be added
back to the net income attribute to common.
■ After-Tax Interest Expense Interest expense (net of any tax savings)

This interest expense is a cash flow intended for the debt providers
In the Philippines, interest expense is a tax-deductible expense for the
company. This means that when the company pays interest, it reduces the
tax to be paid. Hence, the cash outflow is the amount of interest expense
less any tax savings

After-tax interest expense is added back to net income since the

objective of NCF is to measure the cash flows associated with the operating
activity of the business. The impact of financing should be neutralized to
arrive at the real business value based on its operations.
■ Working Capital Adjustment

Also known as working capital, this item

represents the net investment in current assets such
as receivables and inventory reduced by current
liabilities like payables. The amount captured is
based on the movements in these accounts from the
prior year.
■ Investment in Fixed Capital

Pertains to cash outflows made to purchase or pay for capital

expenditures that are required to support existing and future operating
needs. Capital expenditures range from property, plant, and equipment
necessary for production requirements to intangible assets like trademarks,
patents, and copyrights. Firms expect that they will reap benefits for more
than one year as a result of these investments. The investment in fixed
capital assumes that the projects financed are acceptable and have positive
net present value.
 Increases in fixed capital investments use cash, hence a reduction
to Net Cash Flow This is captured in the year that the cash outflow is
made Information related to these can be found in the balance sheet and
statement of cash flows. Once the initial cash payment is made, this is
charged to the succeeding year's income statement as depreciation and
amortization. Treatment for depreciation and amortization applies.

When gaps exist between amount of capital investment and

depreciation (called net capital expenditures), this is usual related to the
growth profile of the company. Company expecting high growth tend to
report high net capital expenditures compared to earnings while low-growth
companies usually have negative net capital expenditures.
 Cash paid for the acquisition of a new business also falls into this
category. The full purchase amount reduces the Net Cash Flow in the year
of acquisition. If the acquisition involves non-cash settlement, analysts
should be careful in capturing only portion denominated in cash as
reduction to Net Cash Flows.

On the other hand, if there are sales of capital expenditures that

occurred, this should be added back to the Net Cash Flow. These sales
increase the cash inflow which consequently reduces the investment in
fixed capital for that period. For example, if a property is sold for
Php1,000,000, then this should reduce the amount of investment in fixed
capital (i.e. ultimately, an addition to net cash flows).
 Hence, net investment in fixed capital is deducted to arrive at Net
Cash Flow computation A negative net investment signifies that firm
received cash since it sold more assets than it purchased for the year

Analyst should use the statement of cash flows to analyze cash flows
related to fixed capital investments There are instances when companies
may obtain fixed capital in exchange of shares which doesn’t necessarily
have impact to cash flows. Even though transactions might be non-cash for
the current year, analysts should be careful in forecasting future fixed
capital investments especially if it will require cash outlays.
B. From Statement Cash Flows
NCF can also be computed using cash flows from operating activities as the
starting point. Analysts usually start from this item since it already
consider’s adjustment for noncash expenses and working capital
investments.
As a refresher, the statement of cash flows classifies cash flows into
three major sections: cash flow from operating activities, cash flow from
investing activities and cash flow from financing activities.
Cash Flows from Operating Activities Php xxx
Add: Interest Expense (net of Taxes)* xxx
Less: Cash Flows from Investing Activities xxx
Net Cash Flows to the Firm Php xxx

*only if deducted from the operations

■ Cash flow from operating activities

This represents how much cash the company generated from

its operations. This shows how much cash is received from
customers and how much cash outflows are paid to vendors. This
also captures changes in current assets and current liabilities.
Normally, this is computed from net income by considering non-
cash items and working capital changes. This is considered in
computing for NCFF.
■ Cash flow from investing activities

This represents how much cash is disbursed (received) for

investments in (sale of) long-term assets like property, plant and
equipment and strategic investments in other companies. This is
considered in computing for NCFF. If this section reflects
transactions involving financial assets, this should be excluded.
■ Cash flow from financing activities

This represents how much cash was raised (or repaid) to

finance the company. This is not considered when computing
NCFF. This is simply because these figures will be accounted for
in the calculation of the Net Cash Flows to the Equity.
Analysts should be mindful how interest and dividends are
classified in the statement of cash flows. IFRS allows interest and
dividends received to be classified under operating or investing
activities while interest and dividends paid out is placed under
operating or financing activities. One-time or extraordinary items
should also be eliminated from the computation.
C. From Earnings Before Interest, Taxes, Depreciation and
Amortization (EBITDA)
EBITDA, net of Taxes Php xxx
Add: Tax Savings on Noncash Charges xxx
Add/Less Working Capital Adjustments xxx
Less Investments in Fixed Capital xxx
Net Cash Flows to the Firm Php xxx
■ EBITDA or Earnings Before Interest, Taxes, Depreciation and
Amortization pertains to income before deducting interest, taxes,
depreciation and amortization expenses, net of taxes.

Since the basis of the computation for the NCFF is already the
earnings after excluding the financing costs, taxes and other non-cash
charges, the NCFF should only consider the amount net of the applicable
taxes to be paid. This to conservatively show the EBITDA at the amount net
to be realized by the investor.
■ Tax Savings on Non-cash charges
Non-cash charges are not typically adjusted if NCFF starts with EBITDA.
However, it is important that analyst should check whether non-cash
charges were already deducted in computing for EBITDA or not. If
deducted, then there is a need to add the item back. If non-cash charges are
not yet deducted from EBITDA, there is no need to add it back to compute
for NCFF.

Instead of adjusting for the full amount, analyst should add back the
corresponding tax savings related to this non-cash charges to EBITDA.
Several non-cash charges such as depreciation and amortization are tax-
deductible. This means that occurrence of these expenses reduces the taxes
that the company should pay, thus, reducing cash outflow. This is added
back to EBITDA to capture this impact.
NET CASH FLOW TO EQUITY

Net Cash Flow to Equity (NCFE) refers to cash available for common
equity participants or shareholders only after paying operating expenses,
satisfying operating and fixed capital requirements and settling cash flow
transactions involving debt providers and preferred shareholders. NCFE can
be computed from NCFF by considering items related to lenders and
preferred shareholders.
NCFE signifies the level of available cash that a business can freely declare
as dividends to its common shareholders. This may still differ significantly
from the dividends actually declared and paid out since this decision is
made upon the discretion of a company’s board of directors. Companies
tend to manage their dividend policy: some slowly increase dividends over
time while some maintain current dividends despite actual profitability. As a
result, dividend trend is seen as less volatile compared to earnings as this is
managed by the board of directors.
Net Cash Flows to the Firm Php xxx
Add: Proceeds from Borrowings xxx
Less: Debt Service xxx
Add: Proceeds from Preferred Shares Issuance xxx
Less: Dividends on Preferred Shares xxx
Net Cash Flows to the Equity Php xxxx
■ Proceeds from Borrowing
This refers to the amount of cash received by the company as a result
of borrowing of long-term debt. Since NCFF did not include items related
to financing, it did not capture cash received by the company from lenders.
Since the cash from the borrowing is with the company already, it is added
back to NCFF and forms part of the cash flow available to common
shareholders.
■ Debt Service
Debt Service is the total amount used to service the loans or debt
financing. This is the total amount of loan repayment and the interest
expenses, net of income tax benefit.

The interest expense is considered as part of the financing activities

and hence deducted from Net Cash Flow since this is associated with long-
term debt of the company. The amount to be included must exclude the
equivalent tax benefits from the interest. The tax benefit must accord with
was allowed by the tax regime where the business operates. Please note that
this amount must be similar should an adjustment was made to compute for
the NCFF.
■ Proceeds from Issuance of Preferred Shares

Same with the debt, preferred shares as another form of financing,

other than the issuance of ordinary equity, must also be factored in the
calculation of the net cash flows available to equity.

■ Dividends on Preferred Shares

Since payments made to preferential shareholders in the form of

dividends are outflows. This must be incorporated in the calculation as a
reduction of the net cash flows to equity.
Similarly, given the above formula as guiding principle, NCFE can be determined under
the following approaches:
A. Based from Net Income (or indirect approach)
Net Income Available to Common shareholders Php xxx
Add: Non Cash Charges (net) xxx
Add: Interest Expense (net of Taxes) xxx
Add/Less: Adjustment in Working Capital xxx
Less: Net Investment in Fixed Capital
(Purchases – Sales of Fixed Capital Investment) xxx
Net Cash Flows to the Firm xxx
Add: Proceeds from Borrowing xxx
Less: Debt Service xxx
Add: Proceeds from Preferred Shares Issuance xxx
Less: Dividends on Preferred Shares xxx
Net Cash Flows to the Equity Php xxx
B. From Statement of Cash Flows
Cash Flows from Operating Activities Php xxx
Add Interest Expense (net of Taxes)* xxx
Less: Cash Flows from Investing Activities xxx
Net Cash flows to the Firm xxx
Add: Proceeds from Borrowing xxx
Less: Debt Service xxx
Add: Proceeds from Preferred Shares Issuance xxx
Less: Dividends on Preferred Shares xxx
Net Cash Flows to the Equity Php xxx
C. From Earnings Before Interest, Taxes, Depreciation and
Amortization (EBITDA)
EBITDA, net of Taxes Php xxx
Add: Tax Savings on Noncash Charges xxx
Add/Less: Working Capital Adjustments xxx
Less: Investment in Fixed Capital xxx
Net Cash flows to the Firm xxx
Add: Proceeds from Borrowing xxx
Less: Debt Service xxx
Add: Proceeds from Preferred Shares Issuance xxx
Less: Dividends on Preferred Shares xxx
Net Cash Flows to the Equity Php xxx
TERMINAL VALUE
Since GCBO is assumed to operate in a long period of time to almost
perpetuity, the risk and returns are inherent to the opportunity at the end of
the projection period should also be quantified. Furthermore, the economic
value that will be generated by the assets is expected to be stable after some
point in time since the projections are reliant on certain assumptions made.
The challenge for the determination of the value of the asset is to also
account for the economic returns that it will generate in perpetuity. This is
addressed by the Terminal Value. Terminal Value represents the value of
the company in perpetuity or in a going concern environment. In practice,
there are several ways on how to determine the value.
BASIS OF TERMINAL VALUE
1. LIQUIDATION VALUE
Some analysts find that the terminal value be based on the estimated
salvage value of the assets.

2. ESTIMATED PERPETUAL VALUE

Another way to determine the value is by using the farthest cash flows you
can estimate divided by the cost of capital less the growth rate.

TV = Terminal Value
CF n+1 = Farthest net cash flows
r = cost of capital
For example, a Filipino company is expecting for 15% returns for a venture
and assumes that their net cash flows for the next five years are as follows:

Net Cash Flows

Year
(in million Php)
1 5.00
2 5.50
3 6.05
4 6.66
5 7.32
In the given illustration, you may note that the net cash flows are growing
annually. Assuming this is a GCBO, and it is expected that the net cash
flows will behave on a normal trend. The growth rate (g) is computed using
compounded annual growth rate formula: