Estimation of Cash Flows

What are the inputs required for DCF

analysis?
Cash flows
Free cash flows to equity, Free cash flows to firm
Discount rate
Cost of equity, weighted average cost of capital
Estimated life
Asset with finite/infinite life

What are the advantages of holding

Free cash ?

Cash Rich PSUs

Company

Cash Rs in crore

Coal India

Rs 62,236

NMDC

21,026

NTPC

18,738

Oil India

12,137

NHPC

7,976

BHEL

7,845

Bharat Electronics

5,331

SAIL

4,176

Nalco

3,504

Why Free cash Flow Approach is superior to

accounting profit in valuation?

Enron
First $ 100
Billion
Year

Revenues
First
($ millions) $ 10 B
Year

Revenue
Years from
($ millions) $10 B to
$ 100 B

Exxon
Mobil

1980

103,143

1963

10,264

17

Wal Mart

1996

106,147

1986

11,909

10

General
Motors

1986

102,813

1955

12,443

31

Ford

1992

100,786

1965

11,537

27

General
electric

1998

100,469

1972

10,240

26

Enron

2000

100,789

1996

13,289

Enron
2000

1999

1998

1997

1996

1995

Sales

100,789

40,112

31,260

20,273

13,289

9,189

Profit

979

893

703

105

584

520

Fortune
500
ranking

18

27

57

94

141

Estimation of Cash flows

Free Cash Flow to Equity

Free Cash Flow to Firm

What is meant by Free Cash Flows to Equity

(FCFE)
FCFE is the amount an equity investor is entitled to
get in a firm
It is the cash flows leftover after meeting all
expenses, financial obligations, including debt
payments and after meeting the reinvestment needs
of the firm
Investment in Capital assets and additional working Capital
requirement

Investment and Growth

Re 1 invested in infrastructure project translates into 7
times the revenue generation
Economic thumb rule: Logistics sector grow by 1.2 x GDP

XI plan

2008-2012

514 billion
5.10 % 0f
GDP

XII plan

2013-17

1025 billion
7.6 % of GDP

High GDP growth

Rate of above 8 %

Cash Flows to Equity

Cash flows to equity for an unlevered firm
Cash flows to equity for a firm with
leverage.

Cash flows to equity for an unlevered firm

Revenue
operating expenses

xxxxx
xxxxx
----------------EBIDTA
xxxxxx
- depreciation and amortization
xxxxxx
-----------------EBIT
xxxxxx
- taxes
xxxxxx
-----------------Net income
xxxxxxx
+ depreciation and amortization
xxxxxxx
-----------------Cash flows from operations
xxxxxxx
- capital expenditures
- working capital needs
xxxxxxx
------------------Free Cash Flow to Equity
xxxxxxx

Equity DCF valuation

Free Cash Flow to Equity (Unlevered Firm)
Net income
+ depreciation
capital expenditures
change in working capital
= FCFE

Equity DCF valuation

Free Cash Flow to Equity (Unlevered Firm)
Net income
- (Capital expenditure - depreciation)
change in working capital
= FCFE
Net capx

Equity DCF valuation

Free Cash Flow to Equity (levered Firm)

Revenue
operating expenses

xxxxx
xxxxx
----------------EBIDTA
xxxxxx
- depreciation and amortization
xxxxxx
-----------------EBIT
xxxxxx
- Interest
xxxxxx
-----------------EBT
xxxxxx
- taxes
xxxxxx
-----------------Net income
xxxxxxx
+ depreciation and amortization
xxxxxxx
-----------------Cash flows from operations
xxxxxxx
----------------

Cash from operations

- preferred dividends
- Capital expenditure
- working capital needs
- principal repayments
+ proceeds from new debt issues

xxxxxx
----------------

xxxxxx
------------------

Free cash flow to equity

xxxxxxxx
-------------------

Equity DCF valuation

free cash flow to equity (Levered)
Net income
+ depreciation
capital expenditures
change in working capital
principal repayments
+ new debt-issue proceeds
= FCFE

Equity DCF valuation

free cash flow to equity (Levered)
Net income
- (capital expenditures depreciation)
change in working capital
principal repayments
Net debt payments
+ new debt-issue proceeds
= FCFE

Equity DCF valuation

free cash flow to equity (Firm at desired
leverage)
Net income
- (capital expenditure - depreciation) (1 - Debt ratio)
- change in working capital needs (1 Debt ratio)
= FCFE

Cash Flows to Firm

Estimation of cash flows to firm

Cash flow belongs to all stake holders of a firm (Equity

investors, bondholders and preferred stockholders)
Cash flows to firm are those cash flows left-over after
meeting operating expenses and taxes, but before making
payments to any claim holders

Estimation of cash flows to firm

EBIT ( 1-tax rate)
+ Depreciation
- Capital spending
- Working capital needs
= Free cash flow to the firm

Problems in estimation of cash flows

Estimation of Discount Rates

How do you define risk?

Chinese Symbol of Risk

Risk

Expected
return

Meaning of risk

Refers to likelihood that in lifes game of

chance, we will receive outcome that we
will not like.
Websters dictionary defines risk as
exposing to loss or damage
What is the financial definition of risk?

How far the actual return deviates

from expected return?
Expected return

Actual return

Actual return

15 %

Expected return

Risk refers to the likelihood that we will receive a return on an

Investment that is different from the expected return

What is meant by discount rate?

A discount rate is a function of risk involved in
business / asset / project
earning cash flows in the future

The discount rate should cover the price for time

and risk premium.

Estimation of Discount Rates

Equity Valuation
Cost of Equity

Firm valuation
Weighted average cost of capital

CAPM approach

Book value weight

Dividend approach

Market value weight

Cost of equity
What equity investors in a business expect to make
on their investment?
Issues

Unlike debt the cost of

equity is an implicit cost

Expected return need not

be the same for all
investors

Two tasks
1.

To convert implicit cost

in to explicit cost

2.

To come up with a rate

of return common of all
diverse investors.

Risk return models

Estimation Approaches

Risk return models

Estimation Approaches
Step 1: Measuring risk
The spread of actual returns around the expected return
is measured by the variance or standard deviation of the
distribution.
Step2 : Diversifiable and Non diversifiable risk
Refer next slide

Step 3: Assume the marginal investor is well diversified

Step 4: Models measuring Market risk
CAPM, BETA, Risk Free Rate ( no default risk, no uncertainty
about reinvestment rates)
Risk premium ( Survey premiums : Morningstar and Merrill
Lynch) Historical premiums.

Project risk

Project may do better

or worse
than expected

Competitive
risk
Competition
may be stronger
Or weaker than
anticipated

Actions that
affect only one firm

Sector
risk
Entire sector may be
affected

Market risk
Exchange rate and
political risk
Interest rate etc

Actions that
affect all firm

COST OF EQUITY

Capital Asset Pricing Model Approach

Ke = rf + ( Km - Rf )
Ke = cost of equity/ required rate of return
rf = risk free rate of return
Km = expected return on market index

Dividend approach
Ke = D/P + g

Calculation of NOPAT