Calcualtion Fcf

1

CHAPTER 4 FORECASTING CASH FLOWS

In the last chapter, we focused on the question of how best to measure cash flows. In this chapter, we turn to the more difficult question of how best to estimate expected future cash flows. We will begin by looking at the practice of using historical growth rates to forecast future cash flows and then look at the equally common approach of using estimates of growth either from management or other analysts tracking the company. As a final variation, we will describe a more consistent way of tying growth to a firm’s investment and financing policies. In the second part of the chapter, we will examine different ways of bringing closure to valuation by estimating the terminal value and how to keep this number from becoming unbounded. In particular, we will look at the connection between terminal growth and reinvestment assumptions. analysis and simulations. In the final section of the chapter, we will consider three variations on cash flow forecasting - expected value estimates, scenario

The Structure of DCF Valuation To value an asset, we have to forecast the expected cash flows over its life. This can become a problem when valuing a publicly traded firm, which at least in theory can have a perpetual life. In discounted cash flow models, we usually resolve this problem by estimating cash flows for a period (usually specified to be an extraordinary growth period) and a terminal value at the end of the period. While we will look at alternative approaches, the most consistent way of estimating terminal value in a discounted cash flow model is to assume that cash flows will grow at a stable growth rate that can be sustained forever after the terminal year. In general terms, the value of a firm that expects to sustain extraordinary growth for n years can be written as: Value of a firm =

Cash " Expected + r) Flow (1

t t=1 t= n t

+

Terminal Value n (1 + r) n

In keeping with the distinction between valuing equity and...