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Lecture (Free Cash Flow Model - DDM)

The key factors identified in the case that would affect the fund requirements of Arun's new business are: 1. Natural reserve of raw materials like sandalwood in the Mysore region. This ensures steady supply of a key raw material and reduces procurement costs. 2. Liberal credit policy of other raw material suppliers. This provides flexibility in working capital management by allowing delayed payments. 3. Relatively less time required for manufacturing incense sticks. This implies lower working capital needs since inventory holding periods are shorter. The decision taken by Arun as identified from the case is to venture into agarbatti (incense stick) manufacturing by setting up a new production unit in Mysore, considering the favorable factors

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104 views

Lecture (Free Cash Flow Model - DDM)

The key factors identified in the case that would affect the fund requirements of Arun's new business are: 1. Natural reserve of raw materials like sandalwood in the Mysore region. This ensures steady supply of a key raw material and reduces procurement costs. 2. Liberal credit policy of other raw material suppliers. This provides flexibility in working capital management by allowing delayed payments. 3. Relatively less time required for manufacturing incense sticks. This implies lower working capital needs since inventory holding periods are shorter. The decision taken by Arun as identified from the case is to venture into agarbatti (incense stick) manufacturing by setting up a new production unit in Mysore, considering the favorable factors

Uploaded by

Devyansh Gupta
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Free Cash Flow

Model (DDM)
B USINESS VALUATION

 Valuing a business or project


 The value of a business or project is usually computed
as the discounted value of FCF out to a valuation
horizon (H)
 The valuation horizon is sometimes called the
terminal value

FCF1 FCF2 FCFH PVH


PV    ...  
(1  WACC)1
(1  WACC) 2
(1  WACC) H
(1  WACC) H
FCFF AND FCFE

 FCFF and FCFE


F REE C ASH F LOW M ODEL

 Free cash flow method. Suggests the value


of the entire firm equals the present value of
the firm’s free cash flows.

 A firm generates free cash flows for its stock


holders and debt holders, so:

 Market value of a firm=Market value of


stocks + market value of debt
FCF C ONTINUED

• Find the Enterprise Value (EV) of the firm.


– PV of firm’s future FCFs
– FCF = cash providing by operating activities, less capital expenditures
(capex)

• Subtract market value of firm’s debt (and preferred stock, if


any) to get total value of common stock (equity).
– Value of equity = EV of firm – MV of debt

• Divide value of equity by the number of shares outstanding.


– Value per share = value of equity / # of shares of common stock
FCF C ONTINUED

The value of a business is usually computed as


the discounted value of FCF out to a valuation
horizon (H).
 The value after H is sometimes called the
terminal value or horizon value.
FCF1 FCF2 FCFH TVH
PV    ...  
(1  r ) (1  r )
1 2
(1  r ) H
(1  r ) H
FCF C ONTINUED

FCF1 FCF2 FCFH TVH


PV    ...  
(1  r ) (1  r )
1 2
(1  r ) H
(1  r ) H

PV (free cash flows) PV (terminal value)


CONSTANT GROWTH MODEL
(T ERMINAL /H ORIZON VALUE )

•CONSTANT GROWTH MODEL

FCF1
P0 =
r-g
P ROBLEM (T ERMINAL VALUE )

 The return for ABC Company is 21% at present.


This is assumed to continue for the next 5 years.
And after that it is assumed to have a growth @
10% indefinitely.

 The dividend paid for the year is 3.2.

 The required rate of return is 20% .

 What is the Terminal value of the stock as per


constant growth?
P ROBLEM

 Given the long-run gFCF = 6%, and firm discount


rate of 10%, use the corporate value model to
find the firm’s value, if FCF for year 1, 2 and 3
are -5, 10 and 20 respectively.

 If the firm has $40 million in debt and has 10


million shares of stock, what is the firm’s stock
value per share?
G IVEN THE LONG - RUN G FCF = 6%, AND FIRM DISCOUNT
RATE OF 10%, USE THE CORPORATE VALUE MODEL TO
FIND THE FIRM ’ S VALUE .

0 r = 10% 1 2 3 4
...
g = 6%
-5 10 20 21.20
21.20

-4.545
8.264
15.026 21.20
21.20
398.197 530 = = TV3
530 =0.10 - 0.06 ==TV 3
416.942 530
530 = = = TV3TV3
I F THE FIRM HAS $40 MILLION IN DEBT AND
HAS 10 MILLION SHARES OF STOCK , WHAT IS
THE FIRM ’ S STOCK VALUE PER SHARE ?

 MV of equity = MV of firm – MV of debt


= $416.94m - $40m
= $376.94 million
 Value per share = MV of equity / # of shares
= $376.94m / 10m
= $37.69
F REE C ASH FL OW

 Forecast the free cash Flows

 Available for distribution to capital providers after


providing for investments in FA & NWC

 Thus

 FCF= NOPAT-Net Investment

 NOPAT=profit before interest and tax(1-t)


 Net Inv=change in net FA & change in NWC
Calculate the intrinsic value of Equity Share.

P ROBLEM Liabilities Assets

Net Fixed
Shareholder Funds 250 400
Assets

Net
Equity Capital ( 10 crore shares of Rs
100 Working 100
10 each)
Capital

Reserves and Surplus 150


Loan Funds 250
Total 500 Total 500

 The return on invested capital (NOPAT/Invested Capital )of A ltd. is


expected to be12 %.

 The Effective tax rate is 33.33%.

 Debt/Equity=1:1, Kd=9% Ke=16%

 The growth rate in assets, Revenue and NOPAT will be

 20% for first 3 years, 12% for next 3 years and 8% thereafter
WACC Wd 50% Kd 9% Tax 33%
We 50% Ke 16%
S OLUTION
11.00%

1 2 3 4 5 6 7 7
NOPAT 60 72 86.4 103.68 116.1216 130.0562 145.6629 157.3159698
20% 20% 20% 12% 12% 12% 8%
Asset 500 600 720 864 967.68 1083.802 1213.858 1310.966415
Net Investment 100 120 144 103.68 116.1216 130.0562 97.10862

Cash Flow -40 -48 -57.6 0 0 0 48.55431 1747.867827

Preent Value -36.04 -38.96 -42.12 0.00 0.00 0.00 23.39 841.87

Total Value 748.14


Loan Funds Rate 250
Equity Value 498.14

IV 49.81434361
CASELET

 Shubh Ltd. is manufacturing steel at its plant in India. It is enjoying a


buoyant demand for its products as economic growth is about 7%-8% and
the demand for steel is growing. The company has decided to set up a new
steel plant to cash on the increased demand. It is estimated that it will
require about Rs. 2000 crore to set up and about Rs. 500 crore of working
capital to start the new plant.


State the objective of fund raising for this company.

 Identify and state the decision taken by the manager in the above case.

 State any two common factors affecting the Fund requirements of Shubh Ltd.
S OLUTION

 Objectives of fund raising of this company are:


 To ensure availability of sufficient funds from
different sources at reasonable costs.

 To ensure effective utilization of such funds.

 To ensure safety of funds procured by creating


reserves, reinvesting profits, etc.
S OLUTION C ONT …..

 Investment decision/analysis
 It relates to how the firm’s funds are invested in
different assets – fixed assets and working
capital.

 Factors affecting fund requirements of Shubh


Ltd.:
 Nature of business

 Scale of operations
C ASE D ISCUSSION

 Arun is a successful businessman in the paper industry. During his recent


visit to his friend’s place in Mysore, he was fascinated by the exclusive variety
of incense sticks available there. His friend tells him that Mysore region in
known as a pioneer in the activity of Agarbathi manufacturing because it has a
natural reserve of forest products especially Sandalwood to provide for the
base material used in production. Moreover, the suppliers of other types of
raw material needed for production follow a liberal credit policy and the time
required to manufacture incense sticks is relatively less. Considering the
various factors, Arun decides to venture into this line of business by setting
up a manufacturing unit in Mysore. In context of the above case:

 1. Identify of the above case:

 2. Identify the three factors mentioned in the paragraph which are likely to
affect the fund requirements of his business.
Q UIZ

 Balance sheet valuation model for Equity Valuation not


includes

a) Liquidation Value
b) Book Value
c) Replacement Value
d) Goodwill
Q UIZ

 If the intrinsic value of a stock is greater than its market


value, which of the following is a reasonable conclusion?

a) The stock has a low level of risk.


b) The market is fairly valuing the stock.
c) The market is undervaluing the stock.
d) The market is overvaluing the stock.
Q UIZ

 According to the Constant Growth Model

a) The larger the holding period, the higher the stock price
b) The value of a stock depends on the holding period of an
investor
c) The value of a stock is a function of its expected growth rate
in dividends
d) The higher the discount rate, the higher the stock price
Q UIZ

 NOPAT Equals

a) EBIT
b) PAT
c) EPS
d) Net Earnings

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