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Discounted Cash Flow valuation is one of the three primary techniques of financial valuation used by investment banks


Public Trading Comparables


• Public trading analysis


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Cheap University Papers on Discounted Cash Flow Valuation

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• Static analysis/ snapshot in time


Precedent Acquisition Transactions


• Representative acquisition transactions


• Another static analysis


… Still need a valuation technique to assess the long-term prospects of the target, taking into account the risk profile of the company


Discounted Cash Flow


• Net present value of free cash flows (over period of model) and an outer year Terminal Value, meant to value the remaining free cash flow not modeled, out into perpetuity.


• Free cash flow = (i) net income plus (ii) non-cash charges (e.g. depreciation, amortization, deferred taxes) less (iii) net change in working capital less (iv) capital expenditures


Benefits of a DCF


• DCF concept is theoretically rigorous, as opposed to simplified “me to” valuation metrics such as price/earnings, price to book value


• Utilizes concepts of time value of money


• Incorporates concept of cost of capital for a company, and can be structured to evaluate projects regardless of differing capital structures


• Shows how differences in growth and timing of a company’s projections can impact value


• Incorporates a concept of risk -- important as similar sized cash flows may be generated based on different risk profiles, therefore having different valuations


• Is useful to incorporate with sensitivity analysis, assessing how different drivers impact results and valuation over time


Faults to a DCF Analysis


Be careful to avoid a “garbage in, garbage out” analysis


• As inputs to the DCF are crucial, careful consideration must be taken with each of them, as they have the ability to greatly change valuation depending upon the variable choice, etc.


• Usually more dependent on determination of terminal value rather then interim cash flows


• Terminal multiples


• Growth in perpetuity


• Dividend discount model


• Calculation of the discount rate


• Beta


• Risk free rate


• Equity market premium


• Lack of consistency for inputs


• Improper equity market premium


• High growth projections with a low discount rate


• Terminal multiples not consistent with company


• Remember the sanity checks


• “Hurdle rates”


• Valuation multiples today vs. in the future (terminal multiple)


• Underlying financial projections


Discount Rates


• The discount rate is a critical ingredient in a DCF valuation


• The discount rate used should reflect the risk and the type of cash flow being discounted


• Higher risk cash flows should be discounted as a higher discount rate


THE WEIGHTED AVERAGE COST OF CAPITAL (WACC)


• WACC is defined as the weighted average of the costs of the different components of financing used by a company


• WACC = Re(market value of equity / market value of equity plus debt) + Rd(debt / market value of equity + debt)


THE COST OF EQUITY


• The cost of equity is the rate of return that investors require to make an equity investment in a company


• We calculate the cost of equity using the Capital Asset Pricing Model (CAPM)


• CAPM measures the risk associated with any asset by the covariance of its returns with returns on a market index, which is defined to be the asset’s beta


• The cost of equity = Rf + Bl (Rm � Rf)


• Our standard assumptions for the risk free rate (Rf) and the market risk premium (Rm) are


• Rf = the current 10-year Treasury Bond rate


• Rm = [ ], which is the difference between average returns on stocks and average returns on risk free securities over a period of time


THE COST OF DEBT


• The cost of debt is a company’s current after-tax borrowing rate





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