Discounted Cash

Flows Method

Group 3
 DISCOUNTED CASH FLOW METHOD

refers to a valuation method that estimates the value of an investment

using its expected future cash flows. DCF analysis attempts to determine
the value of an investment today, based on projections of how much
money that investment will generate in the future. It works by forecasting
the cash the investment will generate over time and then discounting
those cash flows back to their current value using a discount rate.
Net Cash Flows
Refer to the amount of cash available for distribution to both debt and equity claims of
the business or asset

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.
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 extemal 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.
Net Cash Flow 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.

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Net Income Available to Common
Shareholders
This is the amount left for common
shareholders after deducting all
costs, expenses, depreciation,
amortization, interest, taxes, and
dividends to preferred shareholders.

Non-Cash Charges (Net)

Depreciation and Amortization
 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.

Provisions for Doubtful Accounts

These are estimated amounts 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.
 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 tax to be paid. Hence,
the cash outfiow is the amount of interest
expense less any
tax savings.
 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
prior year.
 Investment in Fixed Capital

Pertains o cash outfiows 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 trademark,
patent and copyrights. Firms expect that they will reap
benefits for more than one year as a result of these
investments. The investments in Fixed Capital assumes that
the projects financed a acceptable and has positive net
present value.
A. Based from Net Incom (or Indirect
Approach
FROM STATEMENT OF CASH FLOWS

NCF can also be computed using cash flows from operating

activities (in the statement of cash flows) as the starting point.
Analysts usually start from this item since it already considers
adjustment for noncash expenses and working capital
investments.

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 • 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.
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 • 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.

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 • 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 wthe quicounted for in the
calculation of the Net Cash Flows to the Equity.

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Earnings Before Interest, Taxes, Depreciation and
Amortization (EBITDA)

EBITDA measures the company's overall financial performance. Pertains to income before
deducting interest, taxes, depreciation and amortization expenses, net of taxes.
 Tax- savings on Non-cash Charges
Non- cash charges are not typically adjusted if NCFF start with EDITBA.
However, it is important that analyst should check whether non-cash
charges were already deducted in computing for EDITBA or not. If
deducted, then there is a need to add the item back. If non-cash
charges are not yet deducted from EDITBA, there is no need to add it
back to compute for NCFF.
NET CASH FLOW TO EQUITY
The Net Cash Flow to Equity refers to the cash flow available to pay out to
equity holders (in the form of dividends) who have invested to finance the
operations of the business enterprise. The actual value paid out from the
equity net cash flow to shareholders is determined by the dividend policy of
the business enterprise.
NET CASH FLOW TO EQUITY

• 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.
NET CASH FLOW TO EQUITY

• Debt Service

Debt service is the total amount used to service the loan debts of 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 kent
debt of the company.
NET CASH FLOW TO EQUITY

• 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.
NET CASH FLOW TO EQUITY NCFE=8,460
ILLUSTRATION:
3. Constant Growth

Challenges for some valuators

is to determine the amount of
required return for a specific
type of asset or investment.

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4. Scientific Estimates

Other valuators especially

those with vast experience
already in some types of
investments use other basis for
them to determine the
reasonable terminal value.

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Other inputs in the Net
Cash Flows
The present value of the Net
Cash Flows represents the
value of the assets. It may be
recalled further that the assets
are financed by debt and
equity.
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 Financial Models in Discounted Cash Flows
Analysis

Financial Modelling is a sophisticated and confidential activity

in a company or for an analyst. Most of the companies hire
financial modelers to assist them in determining the value of
GCBOs or other opportunities. They also ask them to validate
ballpark estimates and may also be used to determine
impairments.
In order to develop financial models, the following steps
needs to be observed:

1. Gather historical information and references

Historical information must be made available before the

financial model is to be constructed. Historical information
may be generated from, but not limited to the following:
audited financial statements, corporate disclosures,
contracts, and peer information.
2. Establish drivers for growth and assumption

Once all relevant information was gathered and validated,

drivers and assumptions can be established by conducting
financial analysis. Drivers are suggested to be those
validated and is represented by authorities like government
or experts. Growth drivers are normally based on population,
since most of the businesses are consumer goods.

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The usual growth indicators used are:
inflation, population growth, GNP or GDP growth.

In financial modelling, you need the inflation to be

used as driver for certain operating and capital
expenditures. There are two ways to calculate the
value: (1) nominal and (2) real.

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Population growth rate is factored in to serve as a
growth driver for the demand of the product,
particularly for the merchandising or manufacturing
business. The services sector may use the growth rate
in the businesses or the industry or sector that they
are going to serve.

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To illustrate, suppose that in Barangay A in 2022 the
population is 25,200. The survey is conducted in 2023
and the populationis 26,460. Using the formula of
inflation to calculate for population growth rate:

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To illustrate the application, assuming that the estimated
consumption of pande sal in Barangay A is 5 pcs average
per head. If you are going to project the number of pan de
sal to be sold in 2024, it will be 138,915 units computed as
follows:

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3. Determine the reasonable cost of capital

In determining the reasonable cost of capital, the financial

modeler must be able to use the appropriate parameters
for the company. Generally, cost of debt and cost of
equity are weighted to determine the cost of capital
reasonable for the valuation.

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4. Apply the formulae to compute for the value

Normally in Financial Modelling, DCF is used to calculate for

the value. Since most information are already available in
Financial model, it can be easier to use other capital
budgeting techniques like Internal Rate of Retum,
Profitability Index etc.

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For example, Delight Bakery Inc. projected volume of pan de
sal to be sold in Year 1 is 138, 915 units, assuming 5% growth
every year, and the estimated required return of 10%. The pan
de sal is sold at Php15 per unit with a cash net income margin
of 20% Delight's equipment is capable of producing the
volume required for 10 years. It was noted that the company
has outstanding debt of Php500,000.

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5. Make scenarios and sensitivity analysis based
on the results

The advantage of having a financial model is that you

can easily tweak the given information and get the
results immediately. For instance, in the previous
ilustration the cost of capital used is 10%.

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Components of Financial Model
As a quick guide in developing a financial model the following
components are recommended, particularly when using Microsoft
Excel:
1. Title Page
This provides an overview and the project being valued or
assessed.
2. Data Key Results
This sheet summarizes the results of the study.
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Components of Financial Model
3. Assumption Sheet
This sheet summarizes the assumptions used in the model.
4. Pro-forma Financial Statements
This presents the 3 components of the financial statements
namely: Statement of Income, Statement of Financial Position
and Statement of Cash Flows.
5. Supporting Schedules
This is like a subsidiary ledger which provides supporting
computation to the components of the pro forma financial
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statements.
 Thank you
for listening!