Learning Objectives

What You'll Learn Today

By the end of this session, you will be able to:

Section 1

Discounted Cash Flow Overview

Understanding the foundation of intrinsic valuation

💭
Think About It

Why do we discount future cash flows to present value?

Consider: Time value of money, risk, opportunity cost. A dollar today is worth more than a dollar tomorrow.

📖 Key Concept

DCF (Discounted Cash Flow) is an intrinsic valuation method that estimates the value of an investment based on its expected future cash flows. The core principle: An asset's value equals the present value of all its future cash flows.

📊 The DCF Formula

Enterprise Value = Σ [FCFFₜ / (1+WACC)ᵗ] + [TV / (1+WACC)ⁿ]

Where:

  • FCFF = Free Cash Flow to Firm (cash available to all capital providers)
  • WACC = Weighted Average Cost of Capital (discount rate)
  • TV = Terminal Value (value beyond explicit forecast period)
  • n = Number of years in explicit forecast period

📈 DCF Timeline Visualization

FCFF₁
Year 1
FCFF₂
Year 2
FCFF₃
Year 3
FCFF₄
Year 4
FCFF₅
Year 5
TV
Terminal

Each cash flow is discounted back to present value at the WACC

📋 5-Step DCF Process

1
Forecast Financials

IS, BS, CF for 5-10 years

2
Calculate FCFF

Free cash flow to firm

3
Estimate WACC

Discount rate

4
Calculate TV

Terminal value

5
Discount & Sum

PV of all cash flows

Section 2

Free Cash Flow to Firm (FCFF)

Calculating cash available to all capital providers

📖 Definition

Free Cash Flow to Firm (FCFF) represents the cash flow available to all capital providers (debt holders and equity holders) after the company has paid all operating expenses, taxes, and made necessary investments in working capital and fixed assets.

📊 Standard FCFF Formula

FCFF = EBIT × (1 - Tax Rate) + D&A - CapEx - ΔNWC
+
EBIT × (1 - Tax Rate)

Net Operating Profit After Tax (NOPAT)

+
Depreciation & Amortization

Non-cash expense (add back)

−
Capital Expenditures

Investment in fixed assets (cash outflow)

−
Change in Net Working Capital

Increase in NWC = cash outflow

=
Free Cash Flow to Firm (FCFF)

✅ Cash Inflows (Add)

  • NOPAT: Operating profit after taxes
  • D&A: Non-cash charges added back
  • NWC Decrease: Releases cash

❌ Cash Outflows (Subtract)

  • CapEx: Investment in PP&E
  • NWC Increase: Ties up cash
  • Taxes: Already in NOPAT
📝 Worked Example

FCFF Calculation Example: Tata Consultancy Services (TCS)

Scenario: You are evaluating TCS's Free Cash Flow to Firm (FCFF) for the upcoming 5 years. You have extracted operating projections from equity research models.

Question: How do you calculate the actual unlevered cash available to TCS's stakeholders given the projections below (₹ in Crores)? Observe the standard formula execution below.
1
Lay Out the Matrix
Assemble the EBIT, Tax array, and assumptions required to bridge from EBIT to FCFF. Apply the corporate Indian tax rate (e.g., 25.17%).
2
Excel Construction
Build the waterfall schedule subtracting variables based on standard FCFF conventions. Note that values below are illustrative (in ₹ Crores).
Line Item (₹ Cr) 2025A 2026E 2027E 2028E 2029E 2030E
EBIT 150,000 172,500 198,375 228,131 262,351 301,704
Tax Rate 25% 25% 25% 25% 25% 25%
NOPAT [=EBIT×(1-t)] 112,500 129,375 148,781 171,098 196,763 226,278
+ Depreciation & Amortization 45,000 51,750 59,513 68,439 78,705 90,511
- Capital Expenditures (60,000) (69,000) (79,350) (91,252) (104,940) (120,681)
- Change in NWC (15,000) (8,625) (9,919) (11,407) (13,118) (15,085)
= FCFF 82,500 103,500 119,025 136,878 157,410 181,023
Excel Formulas:
NOPAT: =EBIT*(1-TaxRate)
FCFF: =NOPAT + Depreciation - CapEx - ChangeInNWC

📊 Alternative FCFF Formulas

From Net Income:
FCFF = NI + Int(1-t) + D&A - CapEx - ΔNWC

Add back after-tax interest expense

From EBITDA:
FCFF = EBITDA×(1-t) + D&A×t - CapEx - ΔNWC

Tax shield on depreciation

From CFO:
FCFF = CFO + Int(1-t) - CapEx

Cash from Operations approach

Key Point:

All formulas should give the same FCFF! Choose based on available data.

Section 3

Terminal Value

Capturing value beyond the explicit forecast period

⚠️ Important

Terminal Value typically represents 60-80% of total enterprise value! This makes the terminal value calculation one of the most critical assumptions in a DCF model. Small changes in growth rate or exit multiple can dramatically impact valuation.

📈 Gordon Growth Model (Perpetuity Growth)
TV = FCFFₙ₊₁ / (WACC - g)

Where:

  • FCFFₙ₊₁ = Next year's FCFF (Year after forecast)
  • WACC = Weighted Average Cost of Capital
  • g = Perpetual growth rate
Typical g range: 2-4%
Should not exceed long-term GDP growth (~3-4%)
Best For:
  • ✓ Mature, stable companies
  • ✓ Companies with predictable growth
  • ✓ When perpetuity assumption is valid
📊 Exit Multiple Method
TV = Terminal Year Metric × Exit Multiple

Common multiples:

  • EV/EBITDA = Enterprise Value / EBITDA
  • EV/EBIT = Enterprise Value / EBIT
  • P/E = Price / Earnings (for equity value)
Multiple Selection:
Use current industry median or forward-looking estimate
Best For:
  • ✓ When comparable company data available
  • ✓ Cyclical industries
  • ✓ When growth is hard to estimate
📝 Worked Example

TCS Gordon Growth Terminal Value

Scenario: You've modeled TCS's FCFF out to 2030E (₹181,023 Cr). Based on the Indian macroeconomic environment, you forecast TCS will experience a perpetual mature growth rate (g) of 3.0%.

Question: How do you bridge the year 5 FCFF into a perpetuity Terminal Value?
Assumptions:
FCFF in Year 5 (2030E) 181,023
Perpetual Growth Rate (g) 3.0%
WACC 10.0%
Calculation:
Step 1: FCFF₂₀₃₁ = FCFF₂₀₃₀ × (1 + g)
FCFF₂₀₃₁ = 181,023 × 1.03 = 186,454

Step 2: TV = FCFF₂₀₃₁ / (WACC - g)
TV = 186,454 / (0.10 - 0.03)
TV = 186,454 / 0.07
TV = 2,663,629
Excel Formula:
=FCFF_Year5 * (1 + g) / (WACC - g)
=181023 * 1.03 / (0.10 - 0.03) = 2,663,629
📝 Worked Example

TCS Exit Multiple Terminal Value

Scenario: Instead of perpetual growth, you want to see what TCS would be worth if acquired at the end of Year 5. Based on comparable IT Services transactions, the median exit EV/EBITDA multiple is 7.0x.

Question: How do you calculate the EV value using the assumed 2030E EBITDA of ₹392,215 Cr?
Assumptions:
Year 5 EBITDA (2030E) 392,215
Industry EV/EBITDA Multiple 7.0x
Calculation:
TV = EBITDA₂₀₃₀ × Exit Multiple

TV = 392,215 × 7.0x
TV = 2,745,505
Excel Formula:
=EBITDA_Year5 * Exit_Multiple
=392215 * 7 = 2,745,505

📋 Terminal Value Methods Comparison

Aspect Gordon Growth Exit Multiple
Basis Fundamental (growth rate) Market-based (multiples)
Key Assumption Perpetual growth rate (g) Exit multiple at Year n
Best When Stable, mature companies Good comparable data exists
Limitation Sensitive to g & WACC Market multiples may be distorted
Implied Multiple = (1+g) / (WACC - g) / EBITDA% Directly input
Implied g Directly input = (Multiple × EBITDA% - 1) / (1 + Multiple × EBITDA%)
💡 Best Practice

Cross-check both methods! Calculate TV using both approaches and compare. If Gordon Growth gives ₹2,663,629 and Exit Multiple gives ₹2,745,505, check if the implied growth rate or implied multiple makes sense. This validates your assumptions.

Section 4

Discounting to Present Value

Converting future cash flows to today's value

📊 Present Value Formula

PV = FV / (1 + r)ⁿ

Where:

  • PV = Present Value
  • FV = Future Value (cash flow in year n)
  • r = Discount rate (WACC for FCFF)
  • n = Number of years

🔢 Complete DCF Calculation: Tata Consultancy Services (TCS)

Assuming WACC = 9.5%

Line Item 2026E 2027E 2028E 2029E 2030E Terminal
FCFF 103,500 119,025 136,878 157,410 181,023 2,663,629
Discount Period (n) 1 2 3 4 5 5
Discount Factor =1/1.1^1 =1/1.1^2 =1/1.1^3 =1/1.1^4 =1/1.1^5 =1/1.1^5
Discount Factor 0.9091 0.8264 0.7513 0.6830 0.6209 0.6209
PV of Cash Flow 94,091 98,364 102,831 107,511 112,418 1,653,958
Excel Formulas:
Discount Factor: =1/(1+WACC)^n or =1/POWER(1+WACC, n)
PV of Cash Flow: =FCFF * DiscountFactor

📊 Enterprise Value Calculation

PV of FCFF (2026-2030) 515,215
PV of Terminal Value 1,653,958
Enterprise Value 2,169,173
Less: Net Debt (300,000)
Equity Value 1,869,173
Shares Outstanding 100,000
Price per Share ₹18.69
Value Bridge:
Enterprise Value = Sum of PV(FCFF) + PV(Terminal Value)
Equity Value = Enterprise Value - Net Debt + Non-operating Assets
Price per Share = Equity Value / Shares Outstanding
💡 Advanced: Mid-Year Convention

For more accuracy, use mid-year discounting since cash flows occur throughout the year:
Discount Factor = 1 / (1 + WACC)^(n-0.5)

This increases the PV by about half a year's discounting. Common in professional models.

Excel Lab

Hands-On Practice

Build a complete DCF model

📥 Download Practice Files

Download these files to follow along with the hands-on exercises

📊
lecture-10-dcf.csv
Financial data for DCF practice
⬇
📖
Practice Exercises Guide
Step-by-step DCF exercises
⬇

🎯 Practice Exercises

Exercise 1: Build FCFF Calculation Section

Using the provided data, calculate FCFF for 5 years (2026E-2030E)

Starting Data:
EBIT 2025A: ₹150,000 | Tax Rate: 25%
D&A: 30% of EBIT | CapEx: 40% of EBIT | ΔNWC: 10% of EBIT growth
Revenue Growth: 15% annually

Expected FCFF 2026E: ~₹103,500

Exercise 2: Calculate Terminal Value (Both Methods)

Calculate TV using both Gordon Growth and Exit Multiple methods

Gordon Growth:
g = 3%, WACC = 10%
Expected TV: ~₹2,663,629
Exit Multiple:
EV/EBITDA = 7.0x
Expected TV: ~₹2,745,505

Exercise 3: Complete DCF Valuation

Discount all cash flows and calculate Enterprise Value

Expected Results:
PV of FCFF: ~₹515,215
PV of Terminal Value: ~₹1,653,958
Enterprise Value: ~₹2,169,173

Exercise 4: Sensitivity Analysis

Create a sensitivity table for EV based on WACC and Terminal Growth Rate

WACC / g 2.0% 2.5% 3.0% 3.5% 4.0%
8.0% ? ? ? ? ?
9.0% ? ? ? ? ?
10.0% ? ? ? ? ?
11.0% ? ? ? ? ?
12.0% ? ? ? ? ?

📚 Key Terms - Click to Flip

Knowledge Check

Test Your Understanding

Let's see what you've learned!

Summary

Key Takeaways

📝 What We Covered Today

  • DCF Framework: Enterprise Value = PV(FCFF) + PV(Terminal Value)
  • FCFF Formula: EBIT×(1-t) + D&A - CapEx - ΔNWC
  • Gordon Growth: TV = FCFFₙ₊₁ / (WACC - g), where g ≤ GDP growth
  • Exit Multiple: TV = EBITDA × Exit Multiple (market-based)
  • Terminal Value: Typically 60-80% of total EV - most critical assumption!

📋 Quick Reference - Key Formulas

FCFF
  • =EBIT*(1-t) + D&A - CapEx - ΔNWC
Terminal Value
  • Gordon: =FCFF*(1+g)/(WACC-g)
  • Exit: =EBITDA*Multiple
Present Value
  • =FV/(1+WACC)^n
Enterprise Value
  • =SUM(PV of all FCFF) + PV(TV)
📚 Next Session

Lecture 11: DCF Valuation - II
In the next session, we'll cover WACC calculation in detail, including cost of equity (CAPM), cost of debt, and capital structure weights. We'll also complete a full DCF case study.
Reading: Damodaran, Ch. 7