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Financial Modeling Tutorial: Which Cash Flow to Discount under DCF Approach?

September 24, 2013
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This blog is an extension of our previous blog on “Deciding the Horizon Period for Projections

While presenting my financial model leading to valuation in front of client, I have faced the question below very frequently:

“……You have already projected cash flow statements before coming to the valuation sheet. You have calculated – cash flow from operations, cash flow from investing activities, cash flow from financing activities, net cash flow during the year and then there is a cash & cash equivalent on your projected balance sheet. Why don’t you discount any one of these cash flows under Discounted Cash Flow (“DCF”) approach? What is the need to calculate a separate cash flow for DCF?.....”

If you are finance professional and a seasoned financial modeler, it would not take you long to realize where those who ask this question are coming from? By the time you roll out the valuation sheet of your financial model, you would have calculated so many types of cash flow that an introduction of a new cash flow terminology can test the patience of those sitting on the other side of the table.

But the reality is under DCF approach, we discount none of the cash flows talked above. It’s a totally new cash flow depending upon from hose perspective you are valuing.

If you want to value the firm, you should discount the Free Cash Flow to the Firm (”FCFF”). If you are trying to value the equity portion of the Company, you should discount only the Free Cash Flow to the Equity holders (“FCFE”).

Most of the time we are trying to value the equity portion of the Company. Hence we need to calculate FCFE. So, what is FCFE? The explanation lies in the term itself:

  • A cash flow which is free from all kind of liabilities / claims / potential claims.
  • A cash flow that equity holder can pocket safely.

So, let’s try to make a cash flow free from all kind of liabilities.

1. We can make a cash flow free from all the liabilities for equity holder if all the stakeholders other than equity holders are taken care of. Surplus cash flow left after taking care of all other stakeholders is what will ideally be FCFE. So identify all the stakeholders of a company:

  • Customers
  • Suppliers
  • Employees
  • Lenders
  • Government
  • Shareholders

2. A company serves the contract for products and / or services and satisfies the customers. The moment you execute the contract, customers are satisfied and they make payments to you. There is no liability towards the customers and you are free from any kind of claims from their side. You generate Revenue.

3. In order to satisfy suppliers you make payments to them. Employees are paid their salaries, ages, bonuses, variable pay, commission, retainer etc. Together, you pay all operating expenses. So you end up with Revenue – operating expenses = EBITDA.

4. To satisfy lenders you have to make interest payments and debt repayments and fresh issue of debts as well if required. To satisfy government, you have to pay taxes. So, the flow is

  • Revenue [-] Suppliers Payments [-] employees salaries = EBITDA
  • EBITDA [-] Interest [-] taxes = PAT + Depreciation

5. Please note that this is same as cash flow from operations on accrual basis we discussed while modeling cash flow. In order to convert accrual into realization we have to adjust changes in working capital. Further the resulting cash flow will be used to repay debts or lead to fresh issue of debt in case of shortfall. Besides, company’s growth plans need funding so capital expenditure has to be sponsored from this cash flow.

6. Hence, FCFE, the cash flow free from all kinds of liabilities that can be pocketed by equity holders after taking care of company’s investment plans is given by:

  • FCFE = PAT + Depreciation – Changes in Working Capital – Debt Repayments + Fresh Debt Issue – Capital Expenditure
  • So, this is the cash flow that needs to be discounted if you are valuing the Company from the perspective of equity holders. This will directly yield equity value of the Company hen discounted by the cost of equity.

7. If you are valuing the Firm as a whole, what you need is FCFF. Firm represents both the equity holders and the lenders. Let’s go by the first principle again. This time you need to satisfy following stakeholders before cash flow become free from their claims:

  • Customers
  • Suppliers
  • Employees
  • Government

8. Going by a similar logic as above, you will realize FCFF should be nothing different from:

  • FCFF = EBIT x (1 – Tax Rate) + Depreciation – Changes in Working Capital – Capital Expenditure

9. Recall that a firm is made of equity and lenders. So,

  • FCFF = FCFE + Free Cash Flow to Lenders
  • Free Cash Flow to Lenders = Interest + Debt Repayments – Fresh Issue of Debt
  • On simplification, you realize that many terms cancel each other and your are left with: FCFF = PAT + Depreciation – Changes in Working Capital – Capital Expenditure + Interest

10. FCFF = PBT x (1 – Tax Rate) + Interest + Depreciation – Changes in Working Capital – Capital Expenditure.

Interest can be written as : Interest = Interest x (1 – Tax Rate) + Interest x Tax Rate

11. The last term is interest tax shield. The common practice in the industry is to remove the term from the numerator and give the benefit of interest tax shield in the discount rate represented by WACC in the denominator. Interest x (1 – tax rate) can be clubbed with PBT x (1 – tax rate) to get EBIT x (1 – tax rate). Hence, FCFF becomes:

FCFF = EBIT x (1 – Tax Rate) + Depreciation – Changes in Working Capital – Capital Expenditure

And this should be discounted by WACC after incorporating the interest tax shield in it to get the value of the Firm.

Ever wondered what happens to the fresh equity infusion while calculating FCFF or FCFE?

Do you have any thought on this?

Start a discussion on this topic.

Why equity infusion is not considered a cash inflow and dividend distributed as cash out flow while calculating FCFF or FCFE?


About the Author

Shashi is a B.Tech from Indian Institute of Technology, Delhi and an MBA from Indian Institute of Management (IIM), Ahmedabad. With over 11 years of experience, he has dabbled in Project Management, Management Consulting, Investment Banking, Mergers & Acquisitions, Corporate Finance, Strategy Formulation and Fund Raising.


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