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Chapter 20

4.3 Discounted cash flow basis

The value of equity is derived by estimating the future annual free cash
flows of the entity, and discounting these cash flows at an appropriate
cost of capital (that reflects the systematic risk of the flows).

Free cash flows:

– operating cash flows excluding financing flows

– deduct tax cash flows

– add revenue from sale of assets

– add cash flow benefit of synergies from the merger.

– deduct the cash flow for ongoing asset expenditure, e.g. replacement of worn
out fixed assets

Steps for valuation:

 Identify the free cash flows

 Select a suitable time horizon

 Calculate the PV over this time period (this gives the total value to all providers
of finance, i.e. equity and debt)

 If valuing equity only, deduct the value of the debt (which is now a liability for
the new owner) to give the equity value.

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