Discounted-Cash-Flow Method

The DCF approach in an M&A setting attempts to determine the enterprise value or value of the
company, by computing the present value of cash flows over the life of the company.
1. Because a corporation is assumed to have infinite life, the analysis is broken into two parts: a
forecast period and a terminal value.
a. In the forecast period, explicit forecasts of free cash flow that incorporate the
economic costs and benefits of the transaction must be developed.
b. The terminal value of the company, derived from free cash flows occurring after the
forecast period, is estimated in the last year of the forecast period and capitalizes the
present value of all future cash flows beyond the forecast period. To estimate the
terminal value, cash flows are projected under a steady-state assumption that the firm
enjoys no opportunities for abnormal growth or that expected returns equal required
returns following the forecast period.
Once a schedule of free cash flows is developed for the enterprise, the weighted average
cost of capital (WACC) is used to discount them to determine the present value. The sum of the
present values of the forecast period and the terminal value cash flows provides an estimate of
company or enterprise value.
Key Words : free cash flows, terminal value, and the WACC
The cash-flow forecast should be grounded in a thorough industry and company forecast. Care
should be taken to ensure that the forecast reflects consistency with firm strategy as well as with
macroeconomic and industry trends and competitive pressure
2. A convenient way to think about value creation is whenever the return on net assets (RONA)3
exceeds the WACC.
3. RONA can be divided into an income statement component and a balance sheet.

RONA = NOPAT/ Net Assets

Free cash flows: The free cash flows in an M&A analysis should be the expected
incremental operating cash flows attributable to the acquisition, before consideration of financing
charges (i.e., prefinancing cash flows).
Equation 1: FCF = NOPAT + DEPRECIATION - CAPEX – INC. IN NWC
A terminal value in the final year of the forecast period is added to reflect the present value of all
cash flows occurring thereafter.
Equation 2: Terminal Value = FCFSteady State / WACC
Discount rate -The discount rate should reflect the weighted average of investors’ opportunity
cost (WACC) on comparable investments.
Equation 3 : WACC = Wd Kd (1- t)+ We Ke
 The cost of equity can be obtained from the Capital Asset Pricing Model (CAPM)
Equation 4 : Ke = Rf + B(Rm – Rf)

The M&A Setting

First, we should recognize that there are two parties (sometimes more) in the transaction: an
acquirer (buyer or bidder) and a target firm (seller or acquired)
Some important questions arise in applying our fundamental concepts:
1. What are the potential sources of value from the combination? Does the acquirer
have particular skills or capabilities that can be used to enhance the value of the
target firm? Does the target have critical technology or other strengths that can bring
value to the acquirer?
2. What is the proper discount rate to use?
To unlever a firm beta, one uses the prevailing tax rate (T) and the predeal debt-to-equity ratio (D/E) of
the firm associated with the beta estimate (BL) to solve.

Equation 5: Bu = BL / [1+(1-t) D/E]

Next, one uses the unlevered beta estimate (Bu) or average unlevered beta estimate (if using multiple
firms to estimate the unlevered beta) to relever the beta to the new intended debt-to-equity ratio (D/E* ).

Equation 6 : BL = Bu[1+(1-t) D/E]

3. After determining the enterprise value, how is the value of the equity computed?
Because debt and equity are the sources of capital, it follows that enterprise value (V) equals the sum of
debt (D) and equity (E) values.
Equation 7 : V = D + E
Therefore, the value of equity is simply enterprise value less the value of existing debt.
Equation 8 : E = V – D
4. How does one incorporate the value of synergies in a DCF analysis?
To obtain the steady-state cash flow, we start by estimating sales in

Equation 9 : Sales Steady State = Sales Year 5 * (1+ g).

To estimate the steady-state change in NWC we use the difference in the values for the last two years.

Equation 10 : ˄NWC Steady State = NWC year 5 - NWC Steady State.

These can be more easily handled together by looking at the relation between sales and net property,
plant, and equipment where NPPE is the accumulation of capital expenditures less depreciation. Table 3
shows that in the steady state year NPPE has increased to 11,914. The difference of NPPE gives us the net
of capital expenditures and depreciation for the steady state.
 Equation 11 : ˄NPPE Steady State = NPPE 1995 - NPPE Steady State.

Summing the components gives us the steady-state free cash flow.

Equation 12 : FCF Steady State = NOPAT Steady State + ˄NPPE Steady State.
Therefore, by maintaining steady-state growth across the firm, we have estimated the numerator of the
terminal value formula that gives us the value of all future cash flows beyond Year 5.
Equation 13 : Terminal Value Year 5 = FCF Steady State / (WACC – g ).