Discounted Cash Flow Valuation

University of Chicago Graduate School of Business Entrepreneurial Finance and Private Equity

Steven Kaplan1 A NOTE ON DISCOUNTED CASH FLOW VALUATION METHODS

This note explains and clarifies the two different discounted cash flow methods used to value investments by diversified investors. APV is more flexible than (and usually recommended over) the WACC method for discounting cash flows. At the end of this memo, I provide an example using the two methods. Both methods require calculation of the free cash flows to an all equity investment or firm, FCF, for all the years of the investment. The free cash flow to an all equity investment or firm in year t, FCFt, is equal to: (1) FCFt = ( Earnings Before Interest and Taxest ) x ( 1 - T ) + Depreciationt - Capital Expenditurest - Increase in Net Working Capitalt + othert. where T is a company's marginal tax rate. Other includes any cash flows that are relevant for an allequity firm, but are not included in the other cash flows. Examples of other might include asset sale proceeds or the use of tax-loss carryforwards. In practice, FCFt will vary over time. For ease of presentation and interpretation, some of the explanations and valuations below assume that the free cash flows are perpetuities. 1. Adjusted Present Value (APV)

In this section, I discuss the adjusted present value or APV analysis. This analysis has the following steps. First, we generate the cash flows from running the business as an all equity firm. Second, we discount these cash flows at the appropriate rate for the risk of running the business. Third, we account for the debt tax shields, including any associated with the terminal value and discount these at the appropriate discount rate. Finally, we account for any other cash flow effects that we have not previously incorporated, such as costs of financial distress, incentive benefits or loan subsidies. These too should be discounted at the appropriate rate. a. Where does APV come from? We can obtain...