87. Discounted Cash Flow (dcf) Valuation Model

A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one. Dollar today is worth more than a dollar tomorrow, because the dollar today can be invested to start earning interest immediately. DCF methods based on time value of money, since: -inflation reduces the purchasing power of future dollars relative to current ones, -the uncertainty (risk) surrounding the receipt of a dollar increases as the date of receipt move away into the future; -opportunity cost equal to the return on the forgone investment. Opportunity cost of any investment is the return one could earn on the nest best alternative.

Discounting is process of finding the present value of a future sum. To calculate present value, we discount expected payoffs by the rate of return (opportunity cost of capital, discount rate).

PV= ; NPV = , where - is initial investment into project, r – rate of return (opportunity cost of capital).

General rule for evaluating the project with NPV: NPV>0, accept the investment, NPV<0-reject, NPV=0, the investment is marginal.

Advantages: theoretically, the DCF is the most sound method of valuation, it is forward-looking and depends more on future expectations rather than historical results; it is influenced to a lesser extent by volatile external factors; is less affected by accounting practices and assumptions; it also allows different components of a business or synergies to be valued separately.

Disadvantages: The accuracy of the valuation determined using the DCF method is highly dependent on the quality of the assumptions regarding FCF, terminal value, and discount rate. As a result, DCF valuations are usually expressed as a range of values rather than a single value by using a range of values for key inputs. It is also common to run the DCF analysis for different scenarios, such as a base case, an optimistic case, and a pessimistic case to gauge the sensitivity of the valuation to various operating assumptions.

88. Capital Structure: Differences between Companies

In order to fund its activities a firm typically needs some kind of funding. In financial language, the firm’s chosen set of financing sources is called its capital structure.

Now, there are several ways for a firm to raise finance (funding). One way of dividing the various sources of capital into different types is by labeling it

as internal financing or external financing. Internal financing is a straightforward way for a firm to fund its business. Here, the firm simply uses its own saved profits from earlier years to fund expansions, takeovers, product development or whatever activity the firm needs to finance. If the firm chooses to turn to external financing, on the other hand, it has many more sources to choose from. Overall, external financing can be divided into equity- and debt financing. Basically this means that a firm can issue equity or debt to raise the money it needs.

If the firm chooses to issue equity (i.e., issue more stocks in its own name), then it distributes ownership in the firm to the financiers, and if it chooses to issue debt (i.e., issue corporate bonds in its own name) then it simply borrows money that has to be paid back to the financiers in the future (together with interest). It is important to understand the fundamental difference between debt- and equity-financing. While debt financing requires the borrower to make regular interest rate payments equity financing doesn’t require the borrower to make repayments of any kind (as opposed to interest rate payments, dividends are not obligatory). Equity funding is therefore sometimes called permanent funding. While we will limit ourselves to the most classical source of equity funding in this paper, i.e. the issuance of ordinary stocks, we will separate between several classes

of debt funding. A firm (or government for that matter) can issue debt (borrow money) in various ways. First, of course, it can turn to a bank for an ordinary bank loan. This is the traditional way for a firm to borrow money and although it is less common today than historically it is still very common. More and more, however, firms turn to the capital market for funding. The capital market is made up of all sorts of investors; individuals, other firms, banks, hedge funds, insurance companies etc.

By turning to the capital market, the firm with borrowing needs does not have to turn to banks for funds. Instead, the capital market supplies the funds. In order to tap the capital market for funds, the firm issues bonds (so-called corporate bonds). These bonds require the firm to make regular interest rate payments in addition to pay back the borrowed money at maturity (which for instance could be in one year’s time, in five years or at whatever point in time agreed upon in the bond covenants/contract). As opposed to bank loans, bonds can be bought and sold by the investors in the capital market. This makes the borrower less dependent on having good relations with a borrowing bank.

In addition to banks and the capital market, a firm can also borrow from its employees. An example of this is when a firm sets aside a certain share of the salary to a retirement fund administrated by the firm. Instead of getting the money up-front, the employee is promised a certain amount when retiring. Obviously, this is like a loan given by the employee to the firm. Money that ”belongs” to the 1 For instance, if the electronics firm Samsung wants to use debt as a way of funding its activities it can issue Samsung bonds (which typically are tradable financial instruments just like Samsung stocks). If it instead wants to use equity as a mean of funding its business, it issues Samsung stock (and thereby dilutes the current stock capital). employee is (temporarily) withheld by the firm. If the employee is young, the loan could have a very long maturity.

Finally, leasing, although strictly not defined as borrowing, can at least be seen as an alternative to debt funding. If the firm decides to lease a piece of machinery, a tractor say, instead of buying it with borrowed money, the situation is very similar to if the firm had borrowed the money by a bank. In both cases, the firm has to make regular payments (leasing fees or interest rate payments). There is one important difference between leasing and borrowing, however. At maturity, if the firm had borrowed money to buy the tractor, then the firm would bear the market risk. That is, the risk that the tractor’s value has fallen more than expected. If the firm instead had leased the tractor there would be no risk involved. The firm would simply return the tractor to the leasing firm and that’s that. In neither of the two cases does the firm have to make any initial outlays from its own funds however.