AFMP4
Syllabus B. Advanced Investment Appraisal B4. Valuation and the use of free cash flows

B4a/C2c. Discounted Cashflows 7 / 11

Syllabus B4a/C2c)

B4a) Apply asset based, income based and cash flow based models to value equity. Apply appropriate models, including term structure of interest rates, the yield curve and credit spreads, to value corporate debt.

C2c) Discuss, assess and advise on the value created from an acquisition or merger of both quoted and unquoted entities using models such as:

iii) Cash flow models, including free cash flows.

This is the PV of future cashflows - value of debt

Ok so this example is difficult but let's take it one step at a time..

PBT 80 (all cash)
Capital Investment each year 48
Debt 10 ($120)

Tax = 30%
WACC = 10%

The profits are expected to continue for foreseeable future (perpetuity)

What is the value of equity?

First of all you need to know how to calculate the value of something that lasts forever (like the profits here)

Well this is called a perpetuity

And calculating its PV is easy! Just Divide it by the discount factor!

So say it's a perpetuity of 60 at a discount rate of 4% = 60 / 0.04 = 1,500

In this question the income needs taxing remember!

Solution
Cash inflow 80 x 70% = 56 - 48 = 8 (in perpetuity)

Value of business = 8 / 0.1 = 80m

So the Equity is the value of all the cashflows less value of debt remember

Equity = 80m - (10 x 1.2) = 68m

Advantages of DCF Method

  1. Theoretically best method

  2. Can value part of a company

Disadvantages of DCF Method

  1. Need to estimate cashflows and discount rate

  2. How long is PV analysis for?

  3. Assumes constant tax, inflation and discount rate