DCF Method for Evaluating the Value of Companies: Group Project Description

Step 1: Listing Characteristics of the Company Under Study

Group Project Description

To Use The Cash Flow Analysis Method to Evaluate the Value  of the Following 3 types of Companies

1. A large public Company that has been operating for 20 years plus
2. A private Company that has been operating for the past 10 years
3. A young ( start-up ) company that has been operating for just 2 years

Project Description

Your group is a potential bidder attempting to use the DCF Method to evaluate the offer made to a potential target represented by the following 3 types of companies

The 3 types of firms are:

1. A large public company that has been operating for 20 years plus
2. A private company that has been operating for the past 10 years
3. A young ( start-up ) company that has been operating for just 2 years

As you have learnt in this course and other corporate finance courses, to carry out a DCF analysis, you have to forecast future cash flows. In order to do so, you have to make certain assumptions such as revenues, operating costs etc, the better the assumptions, the better the analysis. Needless to say, the types of assumptions made depend on:

• The very nature ( characteristics ) of the company being looked at
• The operating history of the company ( applied to real companies only )
• The types of risk facing the company

The above are just examples of the parameters your group has to consider in order to come up with a quality  analysis. Some suggestions to properly carry out such an analysis in order to come up with the best estimate of the firm would be:

Step 1

Provide me with a list of detailed and all inclusive characteristics of the company under study. As an example: A large public company, under normal operating conditions would have a fairly stable revenue growth rate as a standalone company after 20 years of operation.

Note for this project, do not work with a real ( actual ) company , but a fictitious  one ( one that your group comes up with in your mind based on the detailed characteristics that you have provided ) !

Step 2

Once you have exhausted your list of characteristics, you can proceed to make meaningful and reasonable assumptions on the key parameters essential for the analysis.

Step 3

After you have gone through Steps 1 and 2, create a typical numerical example (  see Lectures 7 and 8 ) to demonstrate how you can carry out such an analysis for:

1. A large public company
2. A private company

Separately, your group is given a numerical example to work on for a young (  start up ) company. Before proceeding to solve this numerical example, your group has to provide me with the list of all inclusive characteristics of a young company first. Problem to determine the value of a young ( start up company ) using the DCF  method

Company A has just been operating for 2 years and revenues in year (-1) and year(0) were respectively $ 15MM and $114 MM respectively. Capital spending in year (0) was $180MM and current debt outstanding is $200MM. You are also given the following additional information based on assumptions made listed on Page 4:

a.) The forecast revenue growth rate for the next 11 years are given below:

From year (11) onwards, g becomes perpetual.

Note that to estimate the revenue growth rate, one should expect that g would decrease over time as revenue becomes larger, so the key numbers to focus on are the starting and ending revenues ( year (11) ) rather than focusing on the year-by-year rates.

b.) In year (0), EBIT for Company A was $ (80) MM giving an operating margin (OM) of (70) %. For a comparable company having operating for 13 years, the OM is approximately + 10%.Assume the operating margin for the coming 11 years be given as follows:

One can then see the operating margin improves progressively over time! OM is, by definition: OM = EBIT / Revenue

c.) The corporate tax rate is assumed to be zero when Company A is operating at a loss and 40% when the company turns out a positive profit.

d.) Yearly reinvestmentsin capital ( for additional fixed assets and non-cash working capital ) is given to be proportional to the increase in revenues and the proportional constant is the firm's Capital/revenue ratio. In this problem, assume that this ration equals 0.5.

e.) The bottom-up β for Company A for the initial 5 years of operations is 2.5. It then drops by the same amount per year to 1.0 in year (11). This shows that the risk of the company decrease as profitability progressively improves.

f.) 3-month T-bill yields 3% and the market risk premium is assumed to be 4%.

g.) The average cost of debt is 8% based on the firm's latest borrowing rate when the company was operating at a loss, then the rate would drop to 5% in year (11) as profitability improves as measured by the EBIT/I ratio where "I" is the interest payable.

h.) Assume the outstanding debt of $ 200 MM is to stay at this level throughout.

i.) After a total of 13 years of operation, it is safe to assume that the Return on Capital ( ROC ) of Company A to be a constant 10%; implying that: Reinvestment Rate = Stable Growth Rate on Revenue / Constant ROC