Once the assumptions are established, we must compute the free cash flow to the Firm (FCFF). Moving forward, we must only come across data from year six, and thus begin the estimation with EBIT. To account for the tax benefits, we shall factor in its effect on EBIT.
We have not accounted for EBIT in our P&L, so we need to work out the figures quickly. EBIT stands for earnings before interest and taxes; thus, all expenses apart from interest must be subtracted from total income to calculate it.
We factor in the tax shield effect on EBIT after multiplying it with (1-tax rate), then adding all the non-cash charges. We subtract working capital and CAPEX charges to calculate free cash flow to the Firm. I have computed these figures in excel, and my sheet looks like this –
I have created an index for columns E, F, G and H to ensure that the link between columns J to N and years 6 to 10 is consistent with the rest of the sheets. You may arrange this sheet as you find suitable.
EBIT and depreciation figures can be sourced from the P&L. As for working capital and CAPEX, you’ll find them on the cash flow statement. I’ve included a link to download the excel sheet at the end of this chapter, so don’t forget to take a look.
– Terminal Growth value
We now have the free cash flow to the Firm projected up until year 10. We assume that the company will not only survive but also continue to generate free cash flow thereafter. This rate of growth is referred to as the ‘terminal growth rate’, which is typically equal to the country’s long-term inflation rate.
Using your imagination, fast-forward 5 years. Consider all the cash flows over eternity that your company will generate. Now bring that total up to the present year.
To calculate the terminal growth value, use the formula.
= 5th Year cash flow * (1+terminal growth rate)/(WACC-terminal growth rate)
I won’t go into the details of deriving the formula, but that’s what you use to calculate the cumulative sum of all future cash flows.
Here is the calculated value –
The terminal value plays a crucial role in the ultimate valuation of the company, as it is a considerable figure.
We have the next five year’s free cash flow to the firm numbers, as well as the terminal value. Now, we should discount them all and convert them into present-day terms by computing the present value of all the future cash flows.
Three years from now, in Year 8, the free cash flow amounting to 294.14 Cr can be expected. The present value can be calculated from this figure.
= 294.14/ (1+10.25%)^3
= 219.4923 Cr.
We can do this systematically in excel –
I first calculated a discount factor, which is –
1/(1+WACC) ^ (time)
This example requires a three-year period, and the discount factor for its third year is 0.746. I then have to calculate the present value by multiplying this factor with the free cash flow.
So 0.746 * 294.14 = 219.4923Cr.
I have also taken into account the present worth of the terminal growth value.