INVESTMENT BANKING

LESSON 13 DOING A DISCOUNTED FREE CASH FLOW ANALYSIS

Investment Banking (2nd edition) Beijing Language and Culture University Press, 2013

Investment Banking for Dummies, Matthew Krantz, Robert R. Johnson,Wiley & Sons, 2014

WHAT’S IN THE NEWS OR WHAT’S THERE TO LEARN?

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VOCABULARY REVIEW – WHAT DO THESE WORDS MEAN?

Bond indentureFixed income securitiesTypes of bonds:

convertible callableputtable

floating rate zero-couponSeniority

VOCABULARY REVIEW – WHAT DO THESE WORDS MEAN?

Bond trusteeYield to MaturityPremiumDiscountDefault risk

VOCABULARY PREVIEW – This lesson

Present value and discount rate

Discounted free cash flow

Free cash flows (FCF)

Weighted average cost of capital (WACC)

Capital expenditures

LESSON 13 TOPICS

A. INTRODUCTION B. DISCOUNTED FREE CASH FLOW

1. Computing Free Cash Flow (FCF)

2. Forecasting (predicting free cash flow)C. CALCULATING THE WIGHTED AVERAGE COST OF CAPITAL (WACC)

LESSON 13 TOPICS

D. MEASURING THE COST OF DEBT AND EQUITY

1. Cost of Debt

2. Cost of Equity

a. Build-up method

b. Capital Asset Pricing Model (CAPM) – just mentioned but not examined

E. THE VALUE OF A COMPANY USING DISCOUNTED FREE CASH FLOW ANALYSIS

LESSON 13 A. INTRODUCTION

Financial models are the foundation of IB. IB make big pay by showing companies (CEO’s, management) that by issuing or buying back securities, going public or going private, buying companies or make changes in the way the way the company operates, the value of the company can be increased.

LESSON 13 A. INTRODUCTION

The financial value of any company is based on its ability to generate positive cash flow. Financial models are built on the idea that the value of any firm is present value of all future cash flows. This lesson presents the financial model that IB use: the discounted free cash flow model.

LESSON 13 B. DISCOUNTED FREE CASH FLOW

This model requires 2 basic tasks:1. Estimate future cash flows to the firm2. Forecast the right discount rate (the rate that puts future cash sum in today’s dollars).Value = + +….+ +…+is cash flow at time n and r is the discount rate.

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LESSON 13 B. DISCOUNTED FREE CASH FLOW

The formula is the math way of saying, the value of any asset is the present value of all future cash flows. The value of a company is made by a model that estimates free cash flows and discounts them back to the present with a discount rate called the weighted average cost of capital (WACC).

LESSON 13 B. DISCOUNTED FREE CASH FLOW

What is Free Cash Flow (FCF)? The amount of cash flow from operations (CFO) remaining after paying for capital expenditures. CFO is cash flow from business operations that doesn’t include one time items such as a sale of a building or part of a company.