Chapter 9: Discounted Cash Flow Analysis

To value a business using Discounted Cash Flow (DCF) analysis, the key is to calculate and project the appropriate cash
flows – specifically the unlevered free cash flow (UFCF).
Process Overview:
1. Calculate UFCF – This represents the company’s cash flow before interest payments.
2. Project UFCF over several years and discount each year’s cash flow to present value (PV).
3. Estimate Terminal Value – This reflects the business's value after the projection period.

4. Sum of Values:

1. MIDYEAR VS. END-OF-YEAR CONVENTION

The formula for calculating Present Value (PV) is:
Discounting Methods:
● End-of-Year Convention:
○ Cash flows are discounted at full-year intervals.
○ Year 1 is discounted by 1 year, Year 2 by 2 years, etc.
⇒ End-of-year assumes cash flows happen in one lump sum at year-end, while midyear reflects a more gradual flow.
● Midyear Convention:
○ Cash flows are discounted by half-year intervals.
○ Year 1 is discounted by 0.5 years, Year 2 by 1.5 years, and so on.
⇒The midyear convention adjusts for uncertainty regarding when cash flows occur.

2. UNLEVERED FREE CASH FLOW

Unlevered Free Cash Flow (UFCF) represents the cash available to all capital providers, including equity holders and
lenders. It measures cash flow before payments to these groups, reflecting the company’s core operating performance.
● UFCF excludes cash flows related to capital structure, such as dividends, debt transactions, share buybacks, and
financing activities.
● Non-recurring and extraordinary items (like acquisitions or asset sales) are removed to focus on everyday operations.
1. Starting Point – Net Income or EBIT:
● Net Income Approach:
○ Begin with net income and adjust for non-cash items and capital expenditures.
● EBIT Approach (More Common):
○ Starting from EBIT simplifies projections by excluding unnecessary adjustments below EBIT.
2. Adjustments to Cash Flow:
● Depreciation & Amortization (D&A): Non-cash expenses added back.
● Deferred Taxes: Added back to reflect future tax liabilities.
● Other Non-Cash Items: Includes items like stock-based compensation.
● Working Capital Changes:
○ Increase in working capital = Cash Outflow (subtracted from net income on the balance sheet).
○ Decrease in working capital = Cash Inflow.
○ Note: On the cash flow statement, working capital is already adjusted, so it is added directly.
● Capital Expenditures (CAPEX): Subtracted as it represents investment in long-term assets.
● After-Tax (A/T) Net Interest Expense: Added back when starting from net income (since interest has already been
subtracted).

3. Key Clarifications:
● Confusion Around Working Capital:
○ Textbooks often suggest subtracting working capital, but this refers to balance sheet calculations.
○ On the cash flow statement, working capital changes are pre-adjusted and simply added to UFCF.
● Non-Recurring Items:
○ Remove extraordinary or one-time items like asset sales, acquisitions, or marketable securities.
○ Focus solely on recurring operating cash flows.
4. Tax Adjustment for EBIT Approach:
● When starting from EBIT, taxes must be deducted by applying: Taxes=EBIT×Tax Rate
● This reflects the company’s taxable income before interest payments.
3. WEIGHTED AVERAGE COST OF CAPITAL (WACC)
The formula presented in the image is for calculating the Weighted Average Cost of Capital (WACC), which is used to determine
the rate at which a company discounts its future free cash flows (UFCF) to their present value (PV). This rate reflects the
expected return required by both equity investors and debt lenders based on the company's capital structure.

an expanded version of the Weighted Average Cost of Capital (WACC) formula, which includes different types of capital beyond
just debt and equity. The formula is designed to reflect a more detailed capital structure, considering long-term debt, mezzanine
debt, preferred equity, and common equity. Here's the formula:
Long-Term Debt: This part reflects the cost of long-term debt,
adjusted for taxes (since interest payments are tax-deductible).
Mezzanine Debt: This is a form of debt that sits between senior
debt and equity. Its cost is also tax-adjusted.
Preferred Equity: The cost of preferred equity is considered
without any tax adjustments, as preferred payments are typically not
tax-deductible.
Common Equity: This is the cost of common equity, representing
the expected return required by shareholders.

The formula assumes that the interest payments on long-term and mezzanine debts are tax-deductible, while no tax benefit is
assumed for the preferred equity.
WACC should reflect the market value of equity, debts, and interests, so it’s important to use the most current market values to
calculate WACC.

a. Cost of Debt
The cost of debt is the expected return to the debt lenders, or the interest rate. It is important to use the most current interest
rates if available

b. Cost of Equity

1. Capital Asset Pricing Model (CAPM):

The Capital Asset Pricing Model (CAPM) is the most widely used method in investment banking to estimate the cost of equity.
It focuses on the risk associated with an investment and links it to the return that investors expect.
The basic idea is that investors expect a return that compensates them for two things:
● The risk-free rate (usually represented by the return on government bonds, which is considered "safe").
● The market risk premium (the extra return investors expect to receive for taking on the risk of investing in the stock
market as a whole, rather than just holding a risk-free asset).
2. Dividend Discount Model (Dividend Model):
Another method to estimate the cost of equity is the Dividend Discount Model (DDM). This model is useful when a company
pays dividends to its shareholders. According to the dividend model, the cost of equity is equal to:
● The dividend yield (the return from dividends) plus
● The growth rate of dividends (how much the dividends are expected to grow over time).

c. Beta
Beta represents the correlation between the returns of a particular asset and the returns of a
benchmark (such as the S&P 500). ⇒ Essentially, Beta measures how the returns of an asset move
in relation to the overall market.
Calculation of Beta: The beta of an asset is calculated by comparing its historical returns to those of
the market (e.g., the S&P 500).

Leveraging and Unleveraging Beta:

❖ Unlevered Beta: This refers to the beta of a company that does not include any debt in its capital structure. Unlevered
beta is used when estimating a company's risk without considering its leverage (debt).
Levered Beta is the beta of a company that includes both debt
and equity.
Tax Rate represents the company's tax rate.
Debt/Equity ratio reflects the company’s debt relative to its
equity.

❖ Levered Beta: This is the beta of a company that includes the impact of debt (leverage) on its risk. A company with
higher debt levels typically has a higher levered beta because debt increases financial risk.
❖ Re-Levering Beta: When valuing a company, it’s often necessary to re-lever its beta, particularly if you're looking at a
different capital structure (e.g., when comparing a target company’s beta to that of a peer group).
This formula allows you to adjust an unlevered beta to reflect
the specific leverage (debt/equity ratio) of the company you
are evaluating.

Practical Use of Levering/Unlevering Beta:

● In Practice: If you want to compare companies with different debt structures, you can unlever their betas to make them
comparable. After comparing, you may then re-lever the beta to reflect the specific company’s leverage.
● Purpose: The reason for adjusting beta in this way is to isolate the company's business risk (unlevered beta) from the
financial risk that comes from using debt (levered beta).

Cost of Equity:
r_f is the risk-free rate (the return on a safe investment like a government bond).
β (Beta) measures how much the asset’s returns are expected to move relative to the market.
Market Risk Premium: This is the difference between the expected return on the market and the risk-free rate. It represents the
additional return expected for taking on market risk.

➢ Beta helps measure the risk of an asset relative to the market, and it is essential in estimating the cost of equity through
CAPM.
➢ Unlevered beta removes the effects of debt, showing the business risk of a company. Levered beta includes the risk
added by debt.
➢ The process of unlevering and re-levering beta is used to compare companies with different capital structures and
adjust their risk profiles accordingly.
➢ In the CAPM formula, beta plays a central role in determining the cost of equity by indicating how sensitive an asset is to
market movements.
4. TERMINAL VALUE
When estimating the value of a company, it is crucial to consider not just the projected cash flows for a limited number of years
(like five years), but also the value of the business beyond those years.
⇒ The terminal value represents the estimated value of the company after the last projected year and reflects the ongoing value
of the business into perpetuity.
There are two primary methods for calculating the terminal value of a company:

a. Multiple Method
The multiple method estimates the terminal value by applying a multiple to a financial metric (such as EBITDA, EBIT, or
Revenue) for the final projected year.
The multiple is typically derived from comparable companies (peers in the same industry) and represents a reasonable valuation
based on market trends.

b. Perpetuity Method (AKA the Gordon Growth Model):

The perpetuity method assumes that the company will continue to generate cash flows indefinitely, growing at a constant rate
after the final year.
The formula used for calculating terminal value using this method is:
⥀ UFCF is the Unlevered Free Cash Flow in the last projected year.
⥀ g is the perpetual growth rate of UFCF (the long-term growth rate after the final projected year).
⥀ r is the discount rate or WACC (Weighted Average Cost of Capital).
⥀ This method reflects the assumption that the company will continue to grow at a stable rate (g) forever.

⇒ Multiple Method uses industry comparables to estimate the terminal value based on a financial metric.
⇒Perpetuity Method assumes perpetual growth and applies a formula to estimate the terminal value based on the company's
projected future cash flows.
❖ EBITDA Method : For this method, we will take the 2025E EBITDA and multiply it by some EBITDA multiple. It is most
common to take an average or median multiple from the comparable company analyses. We also recommend, as
another conservative approach, to calculate Amazon’s current EBITDA multiple

❖ Perpetuity Method The perpetuity method takes the company’s final projected UFCF and applies the perpetuity
formula: