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Introduction to Discounted Cash Flow Valuation

Introduction to Discounted Cash Flow Valuation. Nicholas Ramm Finance Sector, Madison Investment Fund October 29, 2007. What is DCF analysis?. Method of valuing a financial asset Focus on firms Uses cash flows Find present value of these cash flows. Present Value.

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Introduction to Discounted Cash Flow Valuation

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  1. Introduction to Discounted Cash Flow Valuation Nicholas Ramm Finance Sector, Madison Investment Fund October 29, 2007

  2. What is DCF analysis? • Method of valuing a financial asset • Focus on firms • Uses cash flows • Find present value of these cash flows

  3. Present Value • Value of future money today FV PV= (1+R)T

  4. The Concept-Part 1 Cash Flow Firm Value = $1 + $2 + $3+ $4 + $5 + … (1+R)1 (1+R)2 (1+R)3 (1+R)4 (1+R)5 Discount Rate Need CFs forever

  5. Free Cash Flow • Measure of money available to investors • FCF = (Net Inc.) + (Depreciation/Amortization) - (CapEx) - (Increase in Working Capital) + (Misc. firm-specific items) • All items available in financial statements

  6. Forecasting • Inherently subjective • Choose a forecast period and a method to generate FCFs • Percentage of sales, Construct new financial statements

  7. The Concept-Part 2 Firm Value = FCF1 + FCF2 + FCF3 + FCF4 + FCF5 + … (1+R)1 (1+R)2 (1+R)3 (1+R)4 (1+R)5 Discount Rate Need CFs forever

  8. Terminal Year • Can’t forecast forever • Assume company stabilizes • Grows at G forever

  9. Terminal Year FCFTY * (1 + G) TYV = R - G

  10. The Concept-Part 3 Firm Value = FCF1 + FCF2 + FCF3 + FCF4 + FCF5 +…+ TYV (1+R)1 (1+R)2 (1+R)3 (1+R)4 (1+R)5 (1+R)TY Discount Rate

  11. Discount Rate • Cash Flows and Terminal Year Value must be discounted • Need rate that takes into account relative risks of business

  12. Weighted Average Cost of Capital E D R* = RE * RD * * (1-t) + D+E D+E Weighted Average Debt interest rate Obtain Using CAPM

  13. Capital Asset Pricing Model RE = RF + β * (Rm – Rf)

  14. Putting it All Together Firm Value = FCF1 + FCF2 + FCF3 + FCF4 + FCF5 + …+TYV (1+R*)1 (1+R*)2 (1+R*)3 (1+R*)4 (1+R*)5 (1+R*)TY

  15. Limitations • Forecasting error: • Future cash flows • Future capital structure • Terminal growth rate • Assume unchanging firm • Capital Structure • Terminal growth rate

  16. Questions?

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