Estimation of Cash Flows and Discount Rate

8/18/2019 Estimation of Cash Flows and Discount Rate

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Estimation of Cash Flows


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What are the inputs required for DCFanalysis?

• Cash flows – Free cash flows to equity, Free cash flows to firm

• Discount rate – Cost of equity, weighted average cost of capital

• Estimated life – sset with finite!infinite life


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What are the advantages of holdingFree cash ?


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Cash "ich #$%s

Company Cash Rs in crore

Coal &ndia "s '(,()'

*+DC ( ,-('

*.#C /,0)/

1il &ndia (, )0

*2#C 0,30'

42E5 0,/67

4harat Electronics 7,))

$ &5 6, 0' *alco ),7-6


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Why Free cash Flow pproach is superior toaccounting profit in valuation?


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Enron

First $ 100BillionYear

Revenues($ millions)

First$ 10 BYear

Revenue($ millions)

Years from$10 B to$ 100 B

E88on+o9il

3/- -), 6) 3') -,('6 0

Wal – +art 33' -', 60 3/' ,3-3 -

:eneral+otors

3/' -(,/ ) 377 (,66) )

Ford 33( --,0/' 3'7 ,7)0 (0:eneralelectric

33/ --,6'3 30( -,(6- ('

Enron (--- --,0/3 33' ),(/3 6


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Enron2000 1999 1998 199 199! 199"

$ales --,0/3 6-, ( ) ,('- (-,(0) ),(/3 3, /3

#rofit 303 /3) 0-) -7 7/6 7(-

Fortune7--ran;ing

0 / (0 70 36 6


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Estimation of Cash flows

Free Cash Flow to Equity Free Cash Flow to Firm


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What is meant 9y Free Cash Flows to Equity


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>& plan (--/ (- ( 7 6 9illion7@ - A -f:D#

>&& plan (- ) 0 -(7 9illion

0@' A of :D#

&nvestment and :rowth

• "e invested in infrastructure proBect translates into 0

times the revenue generation• Economic thum9 rule 5ogistics sector grow 9y @( 8 :D#

2igh :D# growth"ate of a9ove / A


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Cash Flows to Equity

• Cash flows to equity for an unlevered firm

• Cash flows to equity for a firm withleverage@


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Cash flows to equity for an unlevered firm

"evenue 88888 operating e8penses 88888

E4&D. 888888 depreciation and amorti ation 888888

E4&. 888888

ta8es 888888

*et income 8888888 depreciation and amorti ation 8888888

Cash flows from operations 8888888

capital e8penditures wor;ing capital needs 8888888

Free Cash Flow to Equity 8888888


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Equity DCF valuation – Free Cash Flow to Equity


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"evenue 88888 operating e8penses 88888

E4&D. 888888 depreciation and amorti ation 888888

E4&. 888888

&nterest 888888

E4. 888888

ta8es 888888

*et income 8888888 depreciation and amorti ation 8888888

Cash flows from operations 8888888


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Cash from operations 888888

preferred dividends Capital e8penditure wor;ing capital needs principal repayments proceeds from new de9t issues 888888

Free cash flow to equity 88888888


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*et income depreciation

− capital e8penditures− change in wor;ing capital− principal repayments

new de9t issue proceeds FCFE

Equity DCF valuation – free cash flow to equity


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*et income


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*et income


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Cash Flows to Firm


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Estimation of cash flows to firm

• Cash flow 9elongs to all sta;e holders of a firm


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Estimation of cash flows to firm

E4&. < ta8 rate= Depreciation

Capital spending Wor;ing capital needs

Free cash flow to the firm


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#ro9lems in estimation of cash flows


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Estimation of Discount "ates


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2ow do you define ris;?


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Chinese $ym9ol of "is;

"is; E8pected

return


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+eaning of ris;

• Refers to li#elihoo that in life%s &ame of

chance' e ill receive outcome that eill not li#e

• *e+ster%s ictionary efines ris# as,e-posin& to loss or ama&e.

•*hat is the financial efinition of ris#/


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7 A E8pected return

( ) 6 7

ctual return

2ow far the actual return deviatesfrom e8pected return?

"is; refers to the li;elihood that we will receive a return on an&nvestment that is different from the e8pected return

E8pected return

ctual return


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What is meant 9y discount rate?

• discount rate is a function of ris; involved in – 9usiness ! asset ! proBect – earning cash flows in the future

• .he discount rate should cover the price for timeand ris; premium@


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Estimation of Discount "ates

Equity GaluationCost of Equity

Firm valuationWeighted average cost of capital

C approach

3ivi en approach

Boo# value ei&ht

ar#et value ei&ht


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Cost of e4uity*hat e4uity investors in a +usiness e-pect to ma#e

on their investment/

&ssues

• %nli;e de9t the cost ofequity is an implicit cost

• E8pected return need not 9e the same for allinvestors

.wo tas;s

@ .o convert implicit costin to e8plicit cost

(@ .o come up with a rateof return common of alldiverse investors@


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"is; return modelsEstimation pproaches


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• $tep +easuring ris; – .he spread of actual returns around the e8pected returnis measured 9y the variance or standard deviation of thedistri9ution@

• $tep( Diversifia9le and *on diversifia9le ris; – "efer ne8t slide

• $tep ) ssume the marginal investor is well diversified• $tep 6 +odels measuring +ar;et ris;

– C #+, 4E. , "is; Free "ate < no default ris;, no uncertainty

a9out reinvestment rates= – "is; premium < $urvey premiums +orningstar and +errill

5ynch= 2istorical premiums@

"is; return modelsEstimation pproaches


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ro5ect may o +etter or orse

than e-pecte

Competitionmay +e stron&er6r ea#er than

anticipate

7ntire sector may +eaffecte

7-chan&e rate anpolitical ris# nterest rate etc

ctions thataffect only one firm ctions that

affect all firm

#roBect ris; Competitive ris;

$ector ris;

+ar;et ris;


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C1$. 1F EH%&.I

Capital sset #ricing +odel pproach Dividend approach

e : r f ; < ( m = R f )J e cost of equity! required rate of return

r f ris; free rate of return

J m e8pected return on mar;et inde8

e : 3> ; &


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Calculation of *1# .


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Estimation of Cash Flows and Discount Rate