1.
Discounted Cashflow Valuation: Basis
for Approach
where CFt is the expected cash flow in period t, r is the
discount rate appropriate given the riskiness of the
cash flow and n is the life of the asset.
Proposition 1: For an asset to have value, the expected
cash flows have to be positive some time over the life
of the asset.
Proposition 2: Assets that generate cash flows early in
their life will be worth more than assets that generate
cash flows later; the latter may however have greater
growth and higher cash flows to compensate.

Value of asset =
CF1
(1 +r)1

CF2
(1 +r)2

CF3
(1 +r)3

CF4
(1 +r)4
..... 
CFn
(1 +r)n

2.
Computation of Cash flow
• Cash flow = After tax operating earnings
+ Depreciation
+ non cash items
Operating free
cash inflow less Investment in long term assets
Less Investment in operating working capital
Future Free
Cash outflow = + after tax non operating income/cash flow
+ /- Decrease/increase in non operating assets

3.
DCF Choices: Equity Valuation versus
Firm Valuation
Assets Liabilities
Assets in Place Debt
Equity
Fixed Claim on cash flows
Little or No role in management
Fixed Maturity
Tax Deductible
Residual Claimon cash flows
Significant Role in management
Perpetual Lives
Growth Assets
Existing Investments
Generate cashflows today
Includes long lived (fixed) and
short-lived(working
capital) assets
Expected Value that will be
created by future investments
Equity valuation: Value just the
equity claim in the business
Firm Valuation: Value the entire business

4.
Equity Valuation
Assets Liabilities
Assets in Place Debt
Equity
Discount rate reflects only the
cost of raising equity financing
Growth Assets
Figure 5.5: Equity Valuation
Cash flows considered are
cashflows fromassets,
after debt payments and
after making reinvestments
needed for future growth
Present value is value of just the equity claims on the firm

5.
Equity valuvation
• The value of equity is the present value of
cash flows to the equity investors discounted
back at the rate of return that those equity
investors need to make to break even (the
cost of equity).

6.
Firm Valuation
Assets Liabilities
Assets in Place Debt
Equity
Discount rate reflects the cost
of raising both debt and equity
financing, in proportion to their
use
Growth Assets
Figure 5.6: Firm Valuation
Cash flows considered are
cashflows fromassets,
prior to any debt payments
but after firmhas
reinvested to create growth
assets
Present value is value of the entire firm, and reflects the value of
all claims on the firm.

7.
Firm Valuvation
A firm includes not just the equity, but all claim
holders.
The cash flow to the firm is the collective cash
flow that all claim holders make from the firm,
and it is discounted at the weighted average of
their different costs.

8.
Cash Flows and Discount Rates
• Suppose a firm has employed a total capital of Rs. 100 lakh(
provided equally by 10percent debt and 50000 equity
shares of Rs. 100 each, its cost of equity is 14 percent and
its subject to corporate tax rate of 40 percent . The
projected free cash flow to all investors of the firm for 5
years are given in the table
Year CF to Firm( in lakhs)
1 30
2 20
3 50
4 15
5 60
Compute valuvation of firm and valuvation from perspective
of equityshareholders. Assume 10 percent debt is
repayable at the year end 5 and interest is paid at each year
end

9.
Discounted Cash Flow Valuation:
The Steps
• Estimate the discount rate or rates to use in the valuation
– Discount rate can be either a cost of equity (if doing equity valuation)
or a cost of capital (if valuing the firm)
– Discount rate can be in nominal terms or real terms, depending upon
whether the cash flows are nominal or real
– Discount rate can vary across time.
• Estimate the current earnings and cash flows on the asset, to
either equity investors (CF to Equity) or to all claimholders (CF to
Firm)
• Estimate the future earnings and cash flows on the firm being
valued, generally by estimating an expected growth rate in
earnings.
• Estimate when the firm will reach “stable growth” and what
characteristics (risk & cash flow) it will have when it does.
• Choose the right DCF model for this asset and value it.

10.
Generic DCF Valuation Model
Cash flows
Firm: Pre-debt cash
flow
Equity: After debt
cash flows
Expected Growth
Firm: Growth in
Operating Earnings
Equity: Growth in
Net Income/EPS
CF1 CF2 CF3 CF4 CF5
Forever
Firm is in stable growth:
Grows at constant rate
forever
Terminal Value
CFn
.........
Discount Rate
Firm:Cost of Capital
Equity: Cost of Equity
Value
Firm: Value of Firm
Equity: Value of Equity
DISCOUNTED CASHFLOW VALUATION
Length of Period of High Growth

11.
Economic Value added
• EVA = NOPAT – (WACC * capital
invested)
• Where NOPAT = Net Operating Profits After
Tax
• WACC =Weighted Average Cost of Capital
• Capital invested = Equity + long-term debt at
the beginning of the period
• and (WACC* capital invested) is also known
as finance charge

12.
Economic Value Added
Economic Value Added (EVA) or Economic Profit
is a measure based on the Residual Income
technique that serves as an indicator of
the profitability of projects undertaken.
Its underlying premise consists of the idea that
real profitability occurs when additional wealth
is created for shareholders and that projects
should create returns above their cost of capital

13.
Problem
Sales revenue 500
Less Operating costs 300
Less interest costs 12
Earnings before tax 188
Less Tax 75.2
Earnings after tax 112.8
The firms existing capital consits of Rs. 150 lakh equity
funds having 15 percent cost and Rs. 100 lakh 12 percent
debt. Determine economic value added during the year