1. Modelling Innovation – CHAPTER 5
Free Cash Flow The Weighted Net Present
(FCF) TV Estimation Average Cost of Value of Free
Capital (WACC) Cash-Flows
Chapter 5 - Net present value of free cash-flows1
The final stage in DCF calculation is a straight present value calculation. Some adjustments are necessary at this stage to make the model more realistic,
and essentially to deal with the time of year during which the cash flows are assumed to occur. Once the net present value is determined, the model should be
used to perform a sensitivity analysis. The analysis will be more complete if scenarios are added, either along the way or following the completion of the
analysis.
5.1 What is the mid-period convention?
To determine the NPVof the FCF of a company or project, the period in which the cashflows are generated should be simulated as precisely as possible.
To achieve a greater degree of precision, building a monthly model would be ideal. However, this is not a viable option in most cases as the information is either
not available or would make the model too detailed and burdensome. A simple way to improve the model’s accuracy is to assume that cash flows occur mid-year,
as of 30 June.This is calledthe Mid-Period Convention and, as illustrated below, and it will change the weights used to discount the cash flows every year.
Diagram 1 – Mid-period Convention
2.5 years
1.5 years
0.5 years
31 December 2012 30 June 2013 30 June 2014 30 June 2015
Valuation Date
1
© 2012, Hugo Mendes Domingos and Eduardo Vera-Cruz Pinto
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2. Modelling Innovation – CHAPTER 5
In this case, the Free Cash Flow corresponding to the first year of the projections, 2013, is assumed to occur on 30 June 2013, which means that the
2013 Free Cash Flow will be reverted by 6 months. If the mid-period convention werenot adopted, the 2013 Free Cash Flow would have been discounted for a
full year. Overall, adopting the mid-period convention will slightly increase the DCF value. More importantly, it will result in a more accurate model.
The mid-period convention and the TV (Terminal Value).
The mid-period convention affects the terminal value (TV). The TV, when calculated as a growing perpetuity, is based on the TVthat is assumed to
occur as of 30 June of the final year. When calculating the value using the multiples method, the cash flow is assumed to occur onthat same date, to be consistent.
In the following examples, we consider a short projection period between 2013 and 2014 only. The valuation date is as of 31 December 2012.
The mid-period convention: multiples method
In casethe EBITDA multiple is used to determine the TV, the multiple should be applied to the EBITDA of the last year of the projection period. The
resulting TV is as of 30 June of the final year of the projection period, and therefore, the respective discount rate should be applied to calculate the present value.
Diagram 2 – Mid-period Convention with multiples method
Half-year FCF
Valuation Date
Assumed financial
value for the multiple
on the final day of the
31 December 2012 30 June 2013 31 December 2013 30 June 2014 final year.
Bring backTV to the valuation date.
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3. Modelling Innovation – CHAPTER 5
The mid-period convention: perpetuity method
In this case, the assumption is that the final period’s EBIT and tax occur on 30 June (for consistency). When applying the Gordon formula, the result is
that the perpetuity reverts back to the previous period. This is simply an outcome of the calculation method. As a result, the growth rate should be applied to the
perpetuity value that results from the Gordon formula to make sure that the perpetuity value is taken forward to the final year of the projection period.
Consequently, the discount rate used to calculate the present value of the perpetuity is the same as the one used to calculate the present value of the last year of
financial projections.
Diagram 3 – Mid-period Convention with perpetuity method
Half year FCF
Valuation Date
31 December 2012 30 June 2013 31 December 2013 30 June 2014
Bring backTV to the valuation date.
5.2 Example: detailed company valuation
The following is a detailed example of a company’s valuation for the purposes of illustration. In this example, the management team of AB decided to
publicly express their interest in the acquisition of a company called Innovation Models (IM). A team was mandated to advise the acquirer and assist in the
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4. Modelling Innovation – CHAPTER 5
negotiations, namely, on valuation matters. IM is a stable company that sells cutting-edge industrial goods (Innovation Models rubber).The analyst’s job is to
prepare a DCF valuation to determine the value of IM as of31 December 2013. Given AB’s necessity to make due diligence and negotiate the transaction, this
valuation date seems appropriate. Applicable to all tables below, all periods until 2012 are historical figures, hence the “H”. From 2012 onward, all periods are
estimates, hence the “E”. The current date for this example is April 2013, but we are valuing only 31 December 2013 because it is considered that there are still a
few months left until the closing of the accounts and the first cash flows to be considered are from 2014. The analysts sourced key financial data from public
sources, and IM’s management team provided the following information and projections:
Table 1–Key financial data
Net Debt (EUR M) 4,000
Perpetuity Growth Rate 2%
Issued Shares 700,000,000
Tax Rate 30%
Target Debt Proportion 50%
Table 2 - IM management team's projections
Unit 2009H 2010H 2011H 2012 2013E 2014E 2015E 2016E 2017E 2018E
Operational
Revenues EUR M 3,863 3,975 4,083 4,225 4,369 4,544 4,771 5,105 5,463 5,845
% change % 2.9% 2.7% 3.5% 3.4% 4.0% 5.0% 7.0% 7.0% 7.0%
Gross Margin EUR M 1,468 1,630 1,756 1,732 1,704 1,818 2,004 2,297 2,677 2,864
% margin % 38.0% 41.0% 43.0% 41.0% 39.0% 40.0% 42.0% 45.0% 49.0% 49.0%
EBITDA EUR M 1,082 1,232 1,307 1,310 1,267 1,409 1,574 1,787 2,130 2,280
% margin % 28.0% 31.0% 32.0% 31.0% 29.0% 31.0% 33.0% 35.0% 39.0% 39.0%
EBIT EUR M 788 918 988 959 909 1,045 1,241 1,429 1,803 1,929
% margin % 20.4% 23.1% 24.2% 22.7% 20.8% 23.0% 26.0% 28.0% 33.0% 33.0%
Capex EUR M (386) (477) (531) (465) (524) (545) (477) (511) (437) (468)
% margin % 10.0% 12.0% 13.0% 11.0% 12.0% 12.0% 10.0% 10.0% 8.0% 8.0%
Change in Net Working Capital (NWC) EUR M 4 5 5 8 8 7 9 10 11 12
% change in
revenues % 4.6% 4.8% 4.6% 5.6% 5.3% 4.0% 4.0% 3.0% 3.0% 3.0%
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5. Modelling Innovation – CHAPTER 5
At this stage, the analyst has all the data she needs to perform the Discounted Cash Flow analysis.
The Weighted Net Present
Free Cash Flow
TV Estimation Average Cost of Value of Free
(FCF)
Capital (WACC) Cash-Flows
A critical view
The analyst should critically examine management’s projections. Upon analysing the figures disclosed by IM’s management team, some figures make
little sense considering the financial and strategic context of the company. The following table shows the analyst’s critical analysis before she applies the DCF
method.
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6. Modelling Innovation – CHAPTER 5
Analyst: Growing
revenues in a context in
Table 3–Critical analysis
which the company does
Unit 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Operational Revenues not change its strategy is
(OR) EUR M 3,863 3,975 4,083 4,225 4,369 4,544 4,771 5,105 5,463 5,845
% variation % 2.9% 2.7% 3.5% 3.4% 4.0% 5.0% 7.0% 7.0% 7.0%
not realistic.
Gross Margin (GM) EUR M 1,468 1,630 1,756 1,732 1,704 1,818 2,004 2,297 2,677 2,864
% margin % 38.0% 41.0% 43.0% 41.0% 39.0% 40.0% 42.0% 45.0% 49.0% 49.0% Analyst: Constant
EBITDA EUR M 1,082 1,232 1,307 1,310 1,267 1,409 1,574 1,787 2,130 2,280 growth in Gross
% margin % 28.0% 31.0% 32.0% 31.0% 29.0% 31.0% 33.0% 35.0% 39.0% 39.0% Margins and
EBIT EUR M 788 918 988 959 909 1,045 1,241 1,429 1,803 1,929 decreasing CAPEX in
% margin % 20.4% 23.1% 24.2% 22.7% 20.8% 23.0% 26.0% 28.0% 33.0% 33.0%
percentage of
Capex EUR M (386) (477) (531) (465) (524) (545) (477) (511) (437) (468) Revenues is not
% revenues % 10% 12% 13% 11% 12% 12% 10% 10% 8% 8%
realistic.
Change in Net Working Capital (NWC) EUR M 4 5 5 8 8 7 9 10 11 12
% Revenue Change % 4.6% 4.8% 4.6% 5.6% 5.3% 4.0% 4.0% 3.0% 3.0% 3.0%
Analyst: Net Working Capital
growing at a rate below revenues’
growth rate is not realistic.
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7. Modelling Innovation – CHAPTER 5
Adjustments to the projections
Our analyst’s views have an impact on IM’s valuation. As a result, adjustments to some figures inTable 2are needed to make the DCF valuation more
realistic.
Revenues and Gross Margins
Table 4 - Operational revenue adjustments
IM's Management Team Unit 2014E 2015E 2016E 2017E 2018E
Analyst: A constant
Operational Revenues EUR M 4,544 4,771 5,105 5,462 5,845
growth rate in revenues is
% variation % 4.0% 5.0% 7.0% 7.0% 7.0%
more realistic as there is
Analyst (after revision)
no change in company
Operational Revenues EUR M 4,500 4,635 4,774 4,917 5,065 strategy.
% variation % 3.0% 3.0% 3.0% 3.0% 3.0%
Table 5 - Gross margin adjustments
Analyst: Taking into
account that this company’s
IM's Management Team Unit 2014 2015 2016 2017 2018
market is stable, this
Gross Margin EUR M 1,818 2,004 2,297 2,677 2,864
projection is more realistic.
% margin % 40.0% 42.0% 45.0% 49.0% 49.0%
These Gross Margins were
Analyst (after revision)
determined using the
Gross Margin EUR M 1,818 1,872 1,928 1,986 2,046 adjusted revenues in Table 4.
% margin % 40.0% 40.0% 40.0% 40.0% 40.0%
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8. Modelling Innovation – CHAPTER 5
EBITDA, depreciation andamortisation, CAPEX and change in NWC
Table 6 - EBITDA adjustments
IM's Management Team Unit 2014 2015 2016 2017 2018
EBITDA EUR M 1,409 1,574 1,787 2,130 2,280
% margin % 31.0% 33.0% 35.0% 39.0% 39.0% Analyst: Constant
Analyst (after revision) margins appear more
EBITDA EUR M 1,350 1,391 1,432 1,475 1,519 realistic.
% margin % 30.0% 30.0% 30.0% 30.0% 30.0%
Table 7 - Depreciation and amortisation adjustments
IM's Management Team Unit 2014 2015 2016 2017 2018
Dep. Amort EUR M 364 334 357 328 351
Dep. Amort. % 8.0% 7.0% 7.0% 6.0% 6.0% Analyst: Constant
Analyst (after revision) D&Ais more realistic.
Dep. Amort EUR M 360 371 382 393 405
Dep. Amort. % 8.0% 8.0% 8.0% 8.0% 8.0%
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9. Modelling Innovation – CHAPTER 5
Table 8 - CAPEX adjustments
IM's Management Team Unit 2014 2015 2016 2017 2018
Capex EUR M (545) (477) (511) (437) (468)
% Revenue % 12.0% 10.0% 10.0% 8.0% 8.0%
Analyst (after revision) Analyst: Constant %
Capex EUR M (540) (556) (573) (590) (608) of
% Revenue % 12.0% 12.0% 12.0% 12.0% 12.0% revenuesappearmore
realistic.
Table 9 - Net Working Capital adjustments
Analyst: A constant
proportion of NWC
IM's Management Team Unit 2014 2015 2016 2017 2018
Net Working Capital EUR M 7.0 9.1 10.0 10.7 11.5 relative to Revenues is
% Change in more realistic compared
Revenue % 4.0% 4.0% 3.0% 3.0% 3.0%
with the management
Analyst (after revision)
Net Working Capital EUR M 6.6 6.8 7.0 7.2 7.4 team´s optimistic
% Change in projections.
Revenue % 5.0% 5.0% 5.0% 5.0% 5.0%
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10. Modelling Innovation – CHAPTER 5
This marks the end of the preview for Chapter 5. You will be able to view the rest of the contents upon publication of the full e-
book. Thank you for your interest.
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