DCFModelingCourseManual 541c69f0a5dd8

DCF Modeling
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Table of contents
SECTION 1: OVERVIEW
DCF in theory and in practice
Unlevered vs. levered DCF
SECTION 2: MODELING THE DCF

Modeling unlevered free cash flows
Discounting to reflect stub year and mid-year adjustment
Terminal value using growth in perpetuity approach
Terminal value using exit multiple approach
Calculating net debt
Shares outstanding using the treasury stock method
Modeling the weighted average cost of capital (WACC)
Sensitivity analysis using data tables
Modeling synergies

Introduction to valuation
Intrinsic value
The value of a business equals the sum of all the
Cash flowt
t=n
cash flows it will generate, discounted to the present Valuet =
value using a discount rate that reflects the riskiness t=1 (1+discount rate)t
of the business.
Hot dog stand

It is January 1, 2007. Your hot dog stand is expected to generate
$10,500 in 2007, and cash flows are expected to grow 5% each
subsequent year.
Assuming a discount rate (r) of 10%, what is the present value of
cash flows generated in the first 5 years?

5
For illustrative Purposes Only
Hot dog stand
Assuming a discount rate of 10%, what is the present value of cash flows
generated in the first 5 years?
Discount each years cash flows by the discount rate:
Cash flow /
Year Cash flow (1+r)t
2007 10,500.0 9,545.5
2008 11,025.0 9,111.6
2009 11,576.3 8,697.4
2010 12,155.1 8,302.1
2011 12,762.8 7,924.7
Sum: 43,581.21

6
Growth in perpetuity
The value of a business with a perpetual growth Cash flowst+1
rate g is equal to next years cash flows divided by Valuet =
the discount rate minus the growth rate. discount rate growth rate
This is a well-established perpetuity formula in
mathematics.
Hot dog stand

Continuing with our example, assuming the business grows at 5% in
perpetuity, what is the value of the hot dog stand today?

7
Hot dog stand

Continuing with our example, assuming the business grows at 5% in perpetuity, what
is the value of the hot dog stand today?
Using the growth in perpetuity formula, we can arrive at a value for the hot dog
stand as illustrated:
Valuet = 10,500.0 = 210,000.0

(10% - 5%)

8
DCF in theory
The DCF valuation approach is based upon the theory that the value of a business is the
sum of its expected future free cash flows, discounted at an appropriate rate.
Discounted cash flow (DCF) analysis is one of the most fundamental, commonly-used
valuation methodologies. It is a valuation method developed and supported in academia
and also widely used in applied business practices.
DCF in practice
There is no consensus on implementation controversies predominantly over the

estimation of the cost of equity.
Extremely sensitive to changes in operating, exit and discount rate assumptions.
That said, there are general rules of thumb that guide implementation.
Two-stage DCF model is prevalent form

The prevalent form of the DCF model in practice is the two-stage DCF model.
Stage 1 is an explicit projection of free cash flows generally for 5-10 years.
Stage 2 is a lump-sum estimate of the cash flows beyond the explicit forecast period.
In addition to the two-stage DCF, there are multi-stage manifestations of the DCF model
(3-stage, high-low models, etc.) designed to more clearly identify cash flows generated at
different phases in a firms life cycle.
We will focus on the two-stage model in this course, given its prevalence in practice.
9
Two-stage DCF model
Stage 1: Free cash flow projections Stage 2: Terminal value

What is the projected operating and We cannot reasonably project cash flows
financial performance of the business? beyond a certain point.
Typical projection period is 5-10 years As such, we make simplifying assumptions
How do we calculate free cash flows about cash flows after the explicit projection
period to estimate a terminal value that
represents the present value of all the free
t=n
FCFt cash flows generated by the company after
Valuet =
(1 + r)t the explicit forecast period.
t=1
Analysts use both the perpetual growth and
exit multiple methods to estimate terminal
value
Discount rate FCFt+1

Valuet =
Both stages should be discounted to the rg
present using a rate that appropriately
reflects the cost of capital (much more Valuet = Exit EBITDA x multiple
on this later)

10
DCF Advantages
Theoretically, the most sound method Two-stage DCF model visualized
of valuation Discounted Cash Flows
Less influenced by temperamental

450.0
400.0
market conditions or non-economic 400.0
factors 350.0
Can value components of business or 300.0
$ in millions
250.0
synergies separately from the 200.0
business 150.0
72.5 79.7 87.7
100.0 54.5 59.9 65.9
45.0 49.5
DCF Disadvantages 50.0
0.0
Present values obtained are sensitive 2005 2006 2007 2008 2009 2010 2011 2012
to assumptions and methodology Years
Terminal value represents a significant portion of value and is highly sensitive to valuation
assumptions
Need realistic projected financial statements over at least one business cycle (7 to 10
years) or until cash flows are normalized
Sales growth rate, margin, investment in working capital, capital expenditures, and terminal
value assumptions along with discount rate assumptions are key to the valuation

11
Table of contents
SECTION 1: OVERVIEW

Modeling synergies

Unlevered free cash flows (FCF)
An investment property should theoretically equal the present value rental income is
of its rental income (minus required maintenance). In the same unlevered, rental
way, the enterprise value of a firm equals the present value of its income minus
FCF, where the appropriate FCF are before the effect of leverage mortgage is
(meaning FCF has not been adjusted down for interest or principal levered
payments). Such cash flows are called unlevered FCF.
Isnt rental income the same regardless of how the rental property was financed? Isnt it fair
to say that the leverage does not affect the expectation of future rental income? Similarly,
debt-related payments such as interest expense and principal are ignored (i.e. we pretend
there is no debt, or resulting interest expense and tax shield) when calculating FCF used to
determine the enterprise value.
Of course, when discounting the unlevered FCF back to the present, they must be
discounted at a rate commensurate with the riskiness of the cash flows which is
absolutely a function of leverage. In other words, even though the expectation of rental
income is unaffected by leverage, the discount rate applied to determine the present value
of expected rental income is indeed a function of the capital structure and expected returns
of the providers of capital.
Indeed, unlevered FCF should be discounted using the weighted average cost of capital
(WACC), reflecting the costs of debt and equity weighted by their respective proportions of
the total capital invested in the enterprise.

13
Levered free cash flows (FCF)
If I project future rental income of an investment property and discount it to the present
using the WACC, the value obtained will be the total value of the property, or enterprise
value. I can subtract all non-equity claims from this value to arrive at my equity value. This
approach at arriving at equity value is called the unlevered DCF approach because
unlevered FCF are projected and discounted.
Alternatively, If I project future rental income minus interest and principal (i.e. mortgage)
and discount it to the present at the cost of equity, I will directly arrive at my equity value.
This approach is called the levered DCF approach because the projected cash flows are
levered. In other words, interest expense, the interest tax shield, and principal payments
are explicitly projected in the calculation of cash flows, which represent cash flows only to
equity holders, and the discount rate reflects the cost of capital only to equity holders.
Both approaches should theoretically yield the same equity value. In line with
The unlevered DCF approach is the predominant approach for standard practice,
valuing most businesses because it is easier to implement1 (with the we will focus on
exception of the valuation of financial institutions, for which levered unlevered DCF in
DCF is preferred). this module
Footnote 1
For the DCF analysis to be usable, we must assume a relatively stable capital structure for the life of the
business. When using the levered DCF approach and explicitly projecting interest expense and principal
payments in a way that maintains a stable debt/equity ratio, we would have to explicitly recalibrate
debt/equity weights each year, possibly along with the costs of debt and equity themselves. This is far more
difficult to implement than the unlevered DCF approach.
14
The process of DCF analysis
Step #1: Step #2:

Enterprise value
Projecting free Calculating the
(value of operations)
cash flows (FCF) terminal value
Project unlevered Estimate the value Less: Net debt

free cash flows over of the enterprise at
forecast period the end of the Equals: Equity value
(typically 5-10 forecast period
Divided by diluted
years) shares outstanding
Equity value
Discount at the cost of capital Equals: per share

15
DCF Exercise
Shares of company XYZ currently Valuation date: January 1, 2008

trade at $20 per share. Free cash flows for year ending December 31:
The company has net debt (debt 2008 415.0
outstanding less cash & 2009 546.0
equivalents) of $400 million and 2010 594.0
400 million diluted shares 2011 652.0
outstanding. 2012 723.0
You have projected free cash flow
2013 781.0
for XYZ for each year through 2015,
2014 812.0
estimated the terminal value in
2015 843.0
2015, and calculated WACC as
Terminal value in 2015 1,200.0
illustrated.
Weighted average cost of capital 10%
Assuming all cash flows are generated at year-end:

1. Estimate the present value of the projected FCF discounted at the stated WACC
Discount the terminal value back to the present
2. Calculate XYZs implied enterprise value
3. Calculate XYZs equity value
4. Derive fair value per share
5. According to the DCF valuation method, are XYZs shares overvalued or
undervalued? Licensed to Sheikh Sadik. Email address: shehab91@outlook.com
16
Solutions
1. Estimate the PV of the projected FCF discounted at the stated WACC

unlevered free cash flowst = $3,419.8 million
(1+wacc)t Note: Use of financial
t=n
t=1 calculators or the NPV
function in Excel is
2. Discount the terminal value back to the present helpful here
terminal value = $559.8 million
(1+wacc)final projection year
3. Calculate XYZs implied enterprise value

PV of unlevered free cash flows + PV of terminal value = $3,979.7 million
4. Calculate XYZs equity value
Enterprise value Net debt = Equity value = $3,979.7 - $400 = $3,579.7 million
5. Derive fair value per share
Equity value / Diluted shares outstanding = $3,579.7 / 400 = $8.95 per share
6. According to the DCF valuation method, are XYZ shares overvalued or
undervalued?
Answer: overvalued by: $20.00 - $8.95 = $11.05

17
Integrity of projections
DCF is quite sensitive to assumptions for FCF projections, terminal value

assumptions, and changes in the discount rate
Care should be taken to make reliable assumptions. If assumptions are not
reasonable and thoughtful, the results of DCF will reflect this
Garbage in, garbage out
Do not explicitly change discount rate assumptions to adjust value of model only in
sensitivity analysis
Sensitivity analysis
DCF valuation is based on assumptions assumptions for future free cash flows, for
the terminal value, and for the discount rate
Therefore, DCF values should be represented in ranges
Key assumptions to sensitize:
Discount rate
Sales growth
EBITDA margin
WACC
Exit multiple
Perpetuity growth rate Licensed to Sheikh Sadik. Email address: shehab91@outlook.com
18
Table of contents
SECTION 1: OVERVIEW

Modeling synergies

Modeling the DCF
Our case study is Colgate (ticker: CL)
In our case study, we are performing a DCF valuation on Colgate on April 13, 2007.
As of April 13, 2007, CL shares were trading at $67.42 and the latest CL financial report
available is CLs fiscal year 2006 10-K.
Before proceeding, make sure you have downloaded the following files:
1. Colgates 10-K for fiscal year ending December 31, 2006.
2. The DCF model
DCF model includes a tab with a completed financial statement model from the
financial statement modeling module.
The DCF model also includes a completed DCF analysis, as well as a blank DCF
template. We will be working together through the empty template, building the
model step-by-step.
If at any point you run into questions, review the completed DCF tab for guidance.

20
Table of contents
SECTION 1: OVERVIEW

Modeling synergies

Unlevered free cash flows
Unlevered FCF represent the cash flows solely from the operating performance of the
business independent of leverage or non-operating investments. Think of unlevered cash
flows as cash flows for an all-equity financed company with no non-operating assets.
But Colgate does have debt, shouldnt that be factored in somehow?

It should and it will just not in the calculation of cash flows. Recall that to value a house,
you would project rental income and then discount those cash flows, as opposed to
projecting rental income less mortgage (i.e. interest) payments. It is the same idea here
we want to project cash flows for Colgate irrespective of its capital structure. The capital
structure will be reflected later in the estimation of the discount rate, as well as how many
non-equity claims must be subtracted from the derived enterprise value to arrive at the
equity value.
About the tax deductibility of interest expensedoesnt that provide real tax benefits?
Very true. We ignore this for now, but will factor it into the discount rate, by adjusting the
companys cost of debt by the tax shield. More on this later.
Where do we factor in non-operating (investment) assets?

As an addition to the companys enterprise value at the end of the analysis. Barring any
explicit guidance otherwise, record the present value of these investments (excess cash,
short-term investments, etc.) at their balance sheet (book) values.
22
Unleveled free cash flows must be projected and then appropriately discounted to
determine a present value of the company under analysis.
Since firms do not report this figure of free cash flows, analysts must make adjustments
to information provided in the reported financial statements.
Start with EBIT

The typical starting point for calculating unlevered free cash flows is
operating income (operating profit before interest and taxes, or EBIT)
reported on the income statement.
23
Arriving at unlevered free cash flows from EBIT:
Free cash flow calculation Historical Projections

EBIT Income Statement (10-K Analyst research
(Operating income) / 10-Q / PR / Company) Company
Use normalized EBIT Internal projections
EBIT (1 tax rate) Use effective tax rate Use marginal tax rate
(Tax-effected EBIT, EBIAT or NOPAT)
Plus: Depreciation and amortization CFS / IS / Footnotes Analyst research
Less: Increases in working capital assets2 Company
Plus: Increases in working capital liabilities Internal projections
Less: Increases in deferred tax assets
Plus: Increases in deferred tax liabilities
Less: Capital expenditures
Less: Other required investments
Equals: Unlevered free cash flows
Footnote calculating levered free cash flows Net income

When valuing financial institutions, levered FCFs are projected to - Increases in working capital
arrive at equity value directly. Projected income and cash flow +/- Deferred taxes
streams are after interest expense and net of any interest income: + D&A
- Capital expenditures
+/- Net borrowing
Levered FCF 24
Projecting unlevered free cash flows
With the exception of the discount rate and shares outstanding, we have already made
most of our projections in the financial statement model. In the DCF the most important
assumptions are:
EBIT and tax rate: From financial model
Depreciation & amortization: From financial model
Capital expenditures: From financial model
Changes in net working capital: From financial model
Synergies: Important in strategic acquisitions; estimate in dollar terms in year one
and evaluate margin impact over time usually projected separately from the core
FCF build-up. To be estimated in the model worksheet.
WACC: To be estimated in the model worksheet.

25
Always remember to:
Footnote assumptions in detail
Test your assumptions
Use consistent cash flows and costs of capital
Reference from core model
Calculation
= days post-deal date / 365
Input WACC of 10% for now

26
Year formula =YEAR(D15)
Insert dynamic date formula as illustrated

27
Reference revenues through tax rate from core

model
In Excel:
1. type =
2. Ctrl Page Up
3. Use arrow keys to find 2007 revenues
4. Hit Enter

28
Calculate EBIAT
Also called NOPAT (Net operating profit after taxes)

29
Reference D&A and working capital inflows/outflows from core model as illustrated
Calculate total cash impact of working capital changes
Reference capital expenditures from the core models cash flow statement. Include any other
required investments when applicable (acquisitions of intangible assets, etc.)

30
Valuation year (year 1)

EBIAT
+ D&A
+/- Changes in working capital
Since the deal date is 4/13/0207 and - Capital expenditures
the first projected years cash flows are Unlevered free cash flows
for the full period 1/1/2007 through X stub year fraction
12/31/2007, we need to subtract a Stub-adjusted free cash flows
portion of the projected free cash flows
since they have presumably already Post-valuation year
been generated prior to the deal date. EBIAT
Adjustment in the model: stub year + D&A
fraction x year 1 projected free cash +/- Changes in working capital
flow - Capital expenditures
Unlevered free cash flows

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Table of contents
SECTION 1: OVERVIEW

Modeling synergies

Calculating present value of FCFs in the model
Now we are ready to calculate the present value of the projected free cash flows.
We will assume a weighted average cost of capital of 10% for now (we will delve into
the components of WACC later).
Present value of cash flow stream: The present value calculation takes into
account the cost of capital by placing greater value on those cash flows generated
earlier in the projection period versus later cash flows1.
PV of FCF = FCF1 + FCF2 + FCF3 + . FCFN

(1+wacc)1 (1+wacc)2 (1+wacc)3 (1+wacc)N
Where N = Last projection year

33
Discount free cash flows back to the present

34
Discount free cash flows back to the present

35
Mid-Year Adjustment
Since most businesses do not generate all of their FCF on the last day of the year,
but rather in a generally continuous basis throughout the year, present value
calculations of FCF are sometimes made using a mid-year convention, which takes
into account the fact that FCF occur throughout the year.
PV of FCFMY = FCF1 + FCF2 + FCF3 + FCFN

(1+wacc)0.5 (1+wacc)1.5 (1+wacc)2.5 (1+wacc)N-0.5
Where N = Last projection year
Note that in the first year, 1 See appendix for detailed

discounting is actually 0.5 of discussion of present value
the stub year fraction calculations

36

37

38
Calculate PV of FCFs

39
Table of contents
SECTION 1: OVERVIEW

Modeling synergies

Terminal value
We have calculated the present value of unlevered FCF for CL through 2015
Clearly the firm is expected to generate cash flows beyond this period, but we cannot
project free cash flows on an annual basis indefinitely with any degree of accuracy
As a result, we make simplifying assumptions at the end of the explicit projection
period in order to calculate terminal value using a perpetuity formula namely, we
assume that after the explicit forecast period, the firm slows down into mature,
normalized, and sustainable EBIAT, growth rates, and WACC
The terminal value represents value of a business at the end of the projection period
Accounts for all the cash flows to be generated beyond the projection period
Assumes that the business is held in perpetuity and that the free cash flows
continue to grow at an assumed perpetual rate
The terminal value often represents a significant portion of the total enterprise value
derived in a DCF model
As a result, the assumptions used to arrive at the terminal value are extremely
important
2 popular methods in practice
There are two common approaches to estimating the terminal value in practice:
Growth in perpetuity method
Exit multiple method Licensed to Sheikh Sadik. Email address: shehab91@outlook.com
41
Terminal value growth in perpetuity method
Assumes that the business will grow in perpetuity after the explicit forecast period at a
constant, long-term nominal industry-demand growth rate1 with normalized FCF and
sustainable WACC.
Implementation: The perpetuity growth method takes the free cash flow in the last year
of the projection period and grows it one more year2. This free cash flow is then divided
by the discount rate (WACC) minus the perpetual growth rate:
Terminal Value t = FCF t+1

(WACC g)
FCF t+1 = FCF in the last projected year * (1+g)

WACC = weighted average cost of capital
g = sustainable perpetual growth rate
1 No business can be expected to have cash flows that grow forever above the economy.
Be conservative when estimating growth rates in perpetuity. In practice long-term
nominal GDP growth is an acceptable proxy.
2 Recall that the perpetuity growth formula is based on the principle that the terminal value
of a business is the value of its next cash flow, divided by the difference between the
discount rate and a perpetual growth rate. Licensed to Sheikh Sadik. Email address: shehab91@outlook.com
42
Terminal value growth in perpetuity method
Additional considerations
If the estimated terminal year + 1 cash flows do not reflect steady-state
relationships between revenues and EBIAT, working capital, capital expenditures and
depreciation, they may need to be revised.
Commonly, higher-growth companies whose capital expenditures during the explicit
forecast period were very high relative to depreciation and revenue growth will need
to be adjusted when calculating the terminal year + 1 free cash flows to reflect lower
required capital investments to sustain lower growth rates. Remember since we are
projecting macroeconomic terminal growth rates, companies should essentially be
spending just enough to replace older equipment.
Working capital may also need to be adjusted to reflect realistic perpetuity working
capital inflows/outflows.
Discounting the terminal value to the present
Once calculated, the terminal value reflects the value at the end of the explicit
projection period.
In order to calculate its present value, it must be discounted back to the valuation
date using the relevant WACC.

43
3-5% growth rate range

Unless specifically instructed
otherwise (with a corresponding
justification), a 3-5% range is
acceptable as the common norm in
non-inflationary environments. A
growth rate greater than 5% is
difficult to justify because it implies
company will grow faster than the
economy this is obviously
unsustainable.

44

45
Mid-year adjustment
The mid-year adjustment
also applies to the growth in
perpetuity formula, which
otherwise assumes all future
cash flows are generated at
year-end.

46
Discounting
Remember that the value
obtained using the perpetuity
formula is for the present value
at the terminal year. This value
must be discounted back to the
valuation date.

47
As you can see, TV typically represents a significant portion of overall value

Care should be taken to reduce dependence on terminal value because it is highly
sensitive to assumptions typically by expanding the explicit projections when possible
What percentage of total value comes from the terminal value?
48
Table of contents
SECTION 1: OVERVIEW

Modeling synergies

Terminal value exit multiple method
In addition to (or instead of) the growth in perpetuity method,

bankers often calculate terminal value by simply forecasting the
purchase price of the business at the end of the explicit forecast
period by applying a current steady-state multiple to some
financial operating metric projected in the final year (usually
EBITDA).
This method is used because it is simple to apply and requires fewer explicit
assumptions about future cash flows, growth, etc.
Of course, the steady-state multiple selected incorporates implicitly all the
assumptions about growth and cash flows embodied in the value driver formula.
Nonetheless, this methods application is somewhat flawed because the multiple
selected is typically derived from market-based valuation, which in turn, is used
to determine intrinsic value.
Both methods are widely used in business valuation, but perpetuity growth
method avoids the fundamental problem of applying a relative, market-based
valuation to arrive at an intrinsic valuation.

50
Terminal value exit multiple method
This method assumes that the business will be valued/sold at the

end of the last year of the projected period:
Generally use an EV / EBITDA multiple: The terminal value
is generally determined as a multiple of EBITDA (or any
relevant statistic). This value will then be discounted to its
present value using the calculated discount rate. If you select a
different statistic, make sure you use an enterprise value
multiple (vs. an equity value multiple) for unlevered DCF and
vice versa.
Multiple should reflect steady-state industry multiple: A steady-state long-term
industry multiple should be used rather than a current industry multiple, which can be
distorted by contemporaneous industry or economic factors.
Multiple derived from comps: Steady-state industry multiples are generally derived
from comparable trading and transaction analyses.
Do not apply mid-year adjustment: Since the derived terminal value represents the
actual purchase price expected on the last day of the explicit projection period, we do
not need to adjust the value for a mid-year adjustment.

51

52

53

54

55
Exit multiple method implied perpetual growth rate
While the exit multiple method is used
more commonly in practice for its Implied g = WACC FCF t+1
simplicity, the growth in perpetuity EBITDA t x multiple
method is more academically sound for
the reasons discussed earlier.
When using an exit multiple, we are making implicit assumptions about the cash flows,
growth and riskiness of the business.
As a result, it is helpful to calculate the implied growth in perpetuity rate arising from the
exit multiple method as a sanity check. If you are using an exit multiple whose implied
perpetual growth rate is substantially above the macroeconomic growth rate, clearly you
are being too aggressive in your assumptions (and vice versa).

56

57

58
Table of contents
SECTION 1: OVERVIEW

Modeling synergies

From enterprise value to equity value
Now that we calculated enterprise value (read the DCF value of operations), our focus
shifts to calculating equity value.
Add non-operating assets
First, all non-operating assets (typically excess cash and other investments) must be
added to the enterprise value.
Net Debt is defined as:
Why? Understand that we just calculated expected cash
flows generated from the operating assets of the business Short-Term Debt
the cash flows related to non-operating assets (i.e. + Current Portion of LT Debt
interest income) were not reflected in the FCF calculation. + Long-Term Debt
Instead the book value of these assets (as identified on + Minority Interest
the most recent 10-K or 10-Q) is typically used as a proxy + Preferred Stock
+ Leases
for the intrinsic value of these assets (the book value of
(Cash + Investments)
cash is, after all, typically the market value of cash, right?) Net Debt
Subtract non-equity claims
Next, all non-equity claims (debt and equivalents) must be
subtracted to identify what the equity in the business is. Net Debt
Include all non-equity claims on the business that have
not been accounted for in the calculation of FCF.
Common items are debt, preferred stock, minority
interests, leases. Equity
Use the book values of these items as proxies for the Value
market value unless instructed otherwise. For illustrative Purposes Only 60

61

62

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Table of contents
SECTION 1: OVERVIEW

Modeling synergies

In order to calculate the equity value per share, we will need to calculate CLs diluted
shares outstanding, where latest diluted shares = latest basic shares + dilutive
securities
Dilutive securities Stock options are issued in stock compensation plans and
Defined as securities that used to pay and motivate employees. This type of security
are not common stock in gives selected employees the option to purchase common
form, but that enable their stock at a given price over an extended period of time.
holders to obtain Warrants are similar to options. They are certificates
common stock upon entitling the holder to acquire shares of stock at a certain
exercise or conversion. price within a stated period. When warrants are exercised,
The most notable the holder must pay a certain amount of money to obtain
examples include stock the shares. Also, when stock warrants are attached to debt,
options, warrants, the debt remains after the warrants are exercised.
convertible bonds, and Convertible bonds company issues bonds which can be
convertible preferred converted into common shares. The conversion feature
stock. For general allows the corporation an opportunity to obtain equity capital
valuation analysis, without giving up more ownership control than necessary
dilution is only assumed and/or entice investors to accept lower interest rates than
from exercisable (vested) they would normally accept on a straight debt issue.
options. For M&A Convertible preferred stock is similar to convertible debt,
analysis, all outstanding except that preferred stock, instead of debt, is originally
options are assumed to issued.
be exercisable. Licensed to Sheikh Sadik. Email address: shehab91@outlook.com
65
Basic shares outstanding

Latest count of basic shares outstanding
(found on the front page of a companys
latest 10-Q or 10-K filed with the SEC)

66
Options
Information about options can usually be found in the footnotes of a companys latest 10-K.
10-Qs do not typically include options data.
This represents a fairly standard layout of the

option data disclosed in a companys option
footnote (10-K only). Use options exercisable
tranches for stand-alone analysis and options
outstanding for M&A valuation.
67
Treasury stock method
Treasury stock method assumes that all proceeds from exercised options and warrants are
used to repurchase outstanding shares.
Treasury stock method example:

Options exercisable Exercise price Status
Tranche 1: 1.5 million $10.00 in-the-money
Tranche 2: 2.0 million $20.00 out-of-the-money
Current stock price: $15.00
Dilutive effect from options: = 1.5 million ($10.00 * 1.5 million) = 0.5 million shares
$15.00

68
Convertible preferred stock
If the company has convertible preferred stock on its balance sheet, and the conversion
price is below the offer value, the preferred stock may be converted to common shares
as follows:
Shares issued = Liquidation value of preferred shares1

Conversion Price2
Companies typically issue preferred dividends, so remember that if we are assuming
preferred stock is being converted to common shares, we must make an adjustment
going forward to exclude this preferred stock from the balance sheet and any preferred
dividends from the income statement.
Convertible debt
Same mechanics as preferred stock
Convertible debt is converted to common shares as follows:
Shares issued = Book value of convertible debt

Conversion Price2
Companies typically pay interest on convertible debt, so if assuming conversion, exclude
this debt from the balance sheet and any associated interest expense from the income
statement.
1 Use preferred stock value on balance sheet
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69
Convertible securities
Information about convertible
securities can usually be found on
the balance sheet and in the
footnotes of a companys 10-K and
10-Qs.

70
Diluted shares
outstanding
Set up the
shares
outstanding
schedule as
illustrated

71
Diluted shares
outstanding
Set up the
shares
outstanding
schedule as
illustrated

72
Total $ proceeds
In-the-$ shares x avg. strike price
Calculate option proceeds using the
SUMPRODUCT function
Total shares repurchased
Proceeds / current share price

73
Convertible securities
Information about
convertible securities can
usually be found on the
balance sheet and in the
footnotes of a companys
10-K and 10-Qs. 74

75

76
Table of contents
SECTION 1: OVERVIEW

Modeling synergies

Weighted average cost of capital
In our model, we inputted a discount rate assumption of 10%. In practice, you may
need to arrive at WACC through a more rigorous analysis.
In an unlevered DCF valuation, the weighted average cost of capital (WACC) is the
appropriate discount rate because we are discounting free cash flows to all providers
of capital.
The WACC, an important assumption in DCF analysis, represents the required rate
of return of an investment given the risks associated with the business. An investor
contributes capital with the expectation that the riskiness of cash flows will be offset
by an appropriate return.
A more intuitive way to think about the discount rate is to think of it as the forecasted
opportunity cost of investing in a particular business vs. in an alternative business
with similar risk.
As such, the cost of capital is typically estimated by studying capital costs for existing
investment opportunities which are similar in nature and risk to the one being
analyzed.

78
Capital structure
Since unlevered DCF assumes a constant WACC throughout the forecast period, a
consistent unlevered DCF valuation requires that companies manage to a target
capital structure that is to say that management will maintain a stable ratio of the
market value of its debt to the market value of its equity.
Substantial deviations from this assumption will require that users adjust their WACC
assumptions for each projection period (both weights and cost of debt and equity).
In this case, other valuation models such as the adjusted present value model may
be easier to work with.
WACC in valuation for M&A

When performing a DCF for M&A, the cost of capital should be calculated based on
the risk profile of the target, not the risk of the acquirer.

79
WACC formula
Since most firms capital structure includes a combination of debt and equity to fund their
operation, the overall cost of capital is the market-based weighted average of the cost of
debt and the cost of equity. The formula for WACC is:
tr = marginal tax rate
WACC = [r debt ] x [1-tr] x [D/(D+E)] + [r equity] x [E/(D+E)] D = market value of debt
E = market value of equity
Market value of equity
Use the market value of the equity (dil. shares x market share price) to calculate the
WACC (even though you are using a market-based valuation of equity to determine the
weight, this calculation is designed only to provide context for a target capital structure).
Estimating private company capital structure
1) Use an equity value derived from a comps analysis for the purposes of calculating
capital structure, or:
2) Use the equity value derived in the DCF valuation to determine the weight. This is also
acceptable for public companies if you expect that the derived fair value of equity is a
better indicator of the future capital structure. Recognize that this creates a circular
calculation because the WACC in turn is used to derive the value of equity, so be sure
that iterations are checked to 100 in Excel under Tools > Options and a circuit breaker
is in place.
80
Market value of debt
In practice, we use the book value of debt as an approximation for market value of debt
unless interest rates have changed substantially since debt issuance. In this case, use the
market price of the companys debt if it is actively traded; otherwise value each bond by
discounting its cash flows (face value x coupon rate) by the yield to maturity of
comparably-rated debt.
Tax shield
Because interest is tax deductible, the true cost of debt is the after-tax rate due to the
ability of interest expense to shield taxes. The tax rate used should be the marginal tax
rate for each specific company.
Tax shield
Tax Think of it this way: $1 of interest expense reduces earnings not by $1, but
shield by $1 x (1 - marginal tax rate) because interest expense is tax deductible
(assuming, of course, that the company is profitable and has sufficient pre-
tax profit to use the shield provided by interest expense).

81
Exercise: Calculate XYZs WACC
Company XYZ has 50 million common shares outstanding trading at $20 per share
It has $200 million in debt outstanding at a 10% interest rate, and this is the current rate
in the market
The marginal tax rate is 40%
The expected equity return in this company is 15%
Calculate XYZs WACC

82
Exercise: Calculate XYZs WACC
WACC = [r debt ] x [1-tr] x [D/(D+E)] + [r equity] x [E/(D+E)]
WACC = [10% (1-40%) x 200/1,200] + [15% x 1,000/1,200]
WACC = 13.5%

83
Cost of debt
The required return on debt rd is directly observable in the market and is best
approximated by the current yield-to-maturity on the companys long-term debt or if
the company has no long-term debt or yields are not observable debt of equivalent
risk (for investment-grade debt).
Bloomberg is a good source for yields and prices.
When determining current yields using debt of equivalent risk, use credit agencies
such as Moodys and S&P which provide yield spreads over US treasuries by credit
rating.
Remember to always use the yield to maturity not the coupon rate since the
coupon rate does not reflect the current market cost of borrowing equivalent debt.
Impact of capital structure on cost of debt

The required return on debt will obviously increase with the level of debt as a
percentage of the capital structure because a more highly levered business has a
higher default risk.

84
Cost of equity
The equity cost of capital is equal to the expected rate of return for a firms equity.
It represents the opportunity cost of investing in a particular business versus an
alternative investment with similar risk.
Difficult to estimate: Since the cost of equity is not readily observable in the market
like cost of debt, it is much more difficult to estimate.
Expected return correlated with risk: Fundamentally, the cost of equity
represents the required rate of return an equity investor applies to expected
equity cash flows to determine how much should be paid for those cash flows. A
higher perceived risk by the investor will require a greater return.
Risk premium: Excluding investors in risk-free investments, all providers of
capital assume risk in some form. Debt holders generally assume a lower risk
than equity holders. Their returns are defined within a narrow range, their
investments are usually secured by the assets of the company and, especially in
the circumstances of bankruptcy or liquidation, they are paid before the equity
holders. Conversely, equity holders share in all the benefits of the upside
whereas debt holders only receive their contractual payments. The range of
possible returns to the equity holders is much greater and, as a result, equity
investment is considered riskier and, hence, more costly.

85
Estimating the equity cost of capital
There are several competing asset-pricing models. The most popular and commonly
used in practice is the capital asset pricing model (CAPM). Other models include the
Fama-French three factor model and the arbitrage pricing model (APT).
The Capital Asset Pricing Model (CAPM) classifies risk into two parts:
1. Unsystematic risk: Company-specific risk that can be eliminated by investing in a
diversified portfolio. Since diversified investors will not consider this risk when
making investment decisions, equity prices will not reflect this risk.
2. Systematic risk: Risk related to investing in the stock market and to sensitivity of
the specific security to the overall market. Since systematic risk is unavoidable,
investors should be rewarded with an equivalent return.

86
Here is a scenario to help illustrate this distinction of risk:
John is not diversified and considers investing in Google.
The risks inherent in investing in the stock market, and
particularly in a company that is so sensitive to market
fluctuations, means that John will expect to be
compensated with at least an annual return of 10%. This
reflects Googles systematic risk.
In addition to these inherent risks, there is also a 10% risk
that company-specific issues will hurt share prices (while
the rest of the industry and stock market do fine). To be
compensated for both risks, John will require a 20%
annual return.
Meanwhile, Susan is diversified and is considering Google as
an investment as well. Her other investments essentially
eliminate her company-specific risk, so she only requires a
10% annual return to compensate her for risks.
As a result, assuming both have equal expectations about
Googles projected cash flows, Susan will be willing to pay
more for Google shares than John. In fact, diversified
investors will bid up the price of Google shares until the
implicit required rate of return equals only the un-diversifiable,
systematic risk of the investment.
87
Capital Asset Pricing Model
The CAPM concludes that the cost of equity equals the risk free rate, plus an
incremental return above the risk-free rate to compensate investors for the additional
risk.
This incremental return equals the market risk premium, common to all companies
and defined as the risk of investing in the market portfolio, times the company
specific beta, which measures the companys sensitivity to stock market changes.
The CAPM formula:

Cost of equity (re) = Risk free rate (rf) + x Market risk premium (rm-rf )
Note: There is also an error term in the CAPM formula, but this is generally omitted

88
Capital Asset Pricing Model
The risk free rate (rf)
Should theoretically reflect yield to maturity of a default-free government bonds of
equivalent maturity to the duration of each cash flows being discounted.
In practice, lack of liquidity in long term bonds, have made the current yield on
10-year U.S. Treasury bonds as the preferred proxy for the risk-free rate for US
companies and the 10-year German Eurobond for European companies.
Bloomberg is a good source for current yields
The market risk premium (rm-rf)

Represents the excess returns of investing in stocks over the risk free rate
There are many competing models used to estimate this premium
Practitioners often use the historical excess returns method, and compare
historical spreads between S&P 500 returns and the yield on 10 year treasury
bonds. A good source for long term historical spreads is the Ibbotson &
Sinquefield yearbook.

89
Beta ()
Beta provides a method to estimate the degree of an assets systematic (non-
diversifiable) risk. Beta equals the covariance between expected returns on the asset
and on the stock market, divided by the variance of expected returns on the stock
market.
Beta is typically calculated by regressing the individual share returns versus the
returns of the market index. The formula for Beta is as follows:
= cov(Ri,Rm)/2(Rm) = (Ri,Rm)(Ri)/ (Rm)
where:
cov(Ri,Rm) = Covariance between security i and the market index
2(Rm) = Variance of the market index
(Ri,Rm) = Correlation coefficient between security i and the market index
(Ri) = Standard deviation of returns of security i
(Rm) = Standard deviation of market returns

90
Interpreting beta
A company whose equity has a beta of 1.0 is as risky as the overall stock market
and should therefore be expected to provide returns to investors that rise and fall as
fast as the stock market. A company with an equity beta of 2.0 should see returns on
its equity rise twice as fast or drop twice as fast as the overall market.
Company xyz returns vs. S&P 500 monthly returns (last 60 months)
20.0%
15.0% Beta = 0.37

S&P 500 returns
2
R = 0.4884
10.0%
5.0%
0.0%
-15.0% -10.0% -5.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
-5.0%
-10.0%
Company XYZ returns
Returning to our CAPM formula, the beta value determines how much of the market
risk premium will be added to the risk-free rate. Since the cost of capital is an
expected value, the beta value should reflect an expected value as well.
91
Application
When daily stock prices for the business are available, some bankers use projected
betas provided by services such as Barra. Other services such as Bloomberg and
S&P also provide Beta calculations, but both are based on historical prices and are
therefore not forward looking. As such, the preferred source of forward looking betas
is Barra.
However, calculating raw betas from historical returns and even projected betas is an
imprecise measurement of future beta because of estimation errors (i.e. standard
errors create a large potential range for beta).
As a result, it is recommended that we use an industry beta. In other words, we
should calculate the unlevered beta (more on this shortly) of companies in the same
industries facing similar operational risks. Assuming the errors are uncorrelated, they
will cancel each other out the more companies are added.
Delevering and relevering betas of comparable companies
Comparable companies with similar operating characteristics may very
well have substantially different financial (capital structure) characteristics.
We need to undo the distorting impact of different capital structures on
beta because more highly leveraged companies will have higher observed
betas. Why? Because cash flows to equity holders are more volatile due
to the higher fixed interest payments
As a result, we need to delever betas of comparable companies so that we can relever
them at the target companys target For
capital structure.
illustrative Purposes Only
92
Delevering beta
(Unlevered) = (Levered)
1+ (Debt/Equity) (1-tr)
(Unlevered) = Unlevered beta

(Levered) = Levered beta
tr = Marginal tax rate
Relevering beta:
Once you have derived the unlevered beta, you need to relever it at the target capital
structure using the reverse of the formula:
(Levered) = (Unlevered) x [1+(Debt/Equity) (1-tr)]

93
Exercise: beta
XYZs observed beta is 1.2

Based on a leveraged balance sheet (it included debt)
XYZs net debt is $15,000 million
Market equity is $140,000 million
Tax rate is 35%
Calculate the companys unlevered beta

94
Exercise: beta
u = lev / 1+(1-T)*(D/E) Notice that when the effect of leverage
u = 1.2 / 1+(1-35%)*(15,000/140,000) is excluded from beta, beta decreases,
u = 1.2 / 1.07 implying less volatile expected returns
u = 1.12 on equity (lower risk).

95

96

97
Calculate the industry beta as illustrated
If your target company is public, WSP recommends
including the company in the group.

98

99

100
Now we can relever the weighted

average industry beta

101
and calculate the cost of equity

102
and the weighted average

cost of capital

103

104
Table of contents
SECTION 1: OVERVIEW

Modeling synergies

Sensitivity (what-if) analysis
Based on the assumptions in our analysis, and given a current share price of
$67.42, are CL shares overvalued, undervalued, or correctly valued?
1. Change the discount rate: What would fair value per share be if the discount
rate assumption was 7%? 8%? 9%? 10%?
2. Change the perpetual growth rate: What would fair value per share be if we
changed the perpetual growth rate assumption to 3%? 5.0%?
3. Change the EBITDA multiple: What would fair value per share be if we
changed the exit multiple assumption to 16.0x instead of 12.0x?
Since the DCF analysis is particularly sensitive to assumptions affecting the discount
rate and terminal value calculation, it is important to perform a sensitivity analysis
This analysis employs data tables to calculate fair value per share based on a range
of assumptions for discount rates and the perpetual growth rates. Commonly
sensitized assumptions include:
The discount rate (WACC)
Terminal growth rate
Sales growth, operating projections
Exit multiples
By observing how the intrinsic value changes if certain assumptions were to be
changed, important insights can be gained

106
Data tables are great tools for sensitivity analysis
Data tables are used to build sensitivity matrices through built-in tool in Excel
Review Wall Street Preps Fundamentals of Financial Modeling Manual for a quick
refresher on constructing Data Tables
Examines a piece of output data such as CLs
intrinsic enterprise value or fair value per share
Analyzes the impact on the output by changing input
variables such as the discount rate, terminal growth
rate, sales growth operating projections, or exit
multiples. Data table dialog box in Excel
Gives a range of possible values based on different
input variable assumptions.
Provides an elegant way to summarize and present
the results of various scenarios.

107

108

109
Table of contents
SECTION 1: OVERVIEW

Modeling synergies

Modeling synergies
Synergies
When valuing a business using the DCF to determine its value for an acquirer, free cash
flow projections may need to include incremental impact of cost savings due to the
acquisition (synergies):
Cost savings (more common): merging companies can often make a significant cut
in expenses by eliminating overlapping workforce, overlapping infrastructure, etc.
Revenues: merging companies, as a result of combined

technology/intellectual property, may be able to bolster their revenue
stream with new products and cross-selling opportunities.
Modeling synergies
Synergies can be discounted independently or by adjusting the explicitly
projected free cash flows.
Common error: When modeling revenue synergies, dont forget that these
incremental revenues have costs associated with them that need to be modeled
in as well (typically at the companys tax-effected EBIT margin).

111
Modeling synergies

112
Modeling synergies

113
Modeling synergies

114
Modeling synergies

115
Modeling synergies

116
Modeling synergies

117
Modeling synergies

118
Modeling synergies

119
Modeling synergies

120
Modeling synergies

121
Modeling synergies

122
Modeling synergies

123
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DCF Modeling

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Self Study Programs Comparable Company Modeling

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SECTION 2: MODELING THE DCF

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Hot dog stand

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Hot dog stand

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Hot dog stand

Valuet = 10,500.0 = 210,000.0

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There is no consensus on implementation controversies predominantly over the

Two-stage DCF model is prevalent form

Stage 1: Free cash flow projections Stage 2: Terminal value

Discount rate FCFt+1

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Less influenced by temperamental

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SECTION 2: MODELING THE DCF

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Step #1: Step #2:

Project unlevered Estimate the value Less: Net debt

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Shares of company XYZ currently Valuation date: January 1, 2008

Assuming all cash flows are generated at year-end:

1. Estimate the PV of the projected FCF discounted at the stated WACC

3. Calculate XYZs implied enterprise value

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DCF is quite sensitive to assumptions for FCF projections, terminal value

SECTION 2: MODELING THE DCF

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SECTION 2: MODELING THE DCF

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But Colgate does have debt, shouldnt that be factored in somehow?

Where do we factor in non-operating (investment) assets?

Start with EBIT

Free cash flow calculation Historical Projections

Footnote calculating levered free cash flows Net income

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Reference from core model

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Year formula =YEAR(D15)

Insert dynamic date formula as illustrated

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Reference revenues through tax rate from core

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Calculate total cash impact of working capital changes

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Valuation year (year 1)

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SECTION 2: MODELING THE DCF

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PV of FCF = FCF1 + FCF2 + FCF3 + . FCFN

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Discount free cash flows back to the present

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