Financial Modeling and Valuation: A Practical Guide to Investment Banking and Private Equity

CHAPTER 8

Discounted Cash Flow Analysis

As discussed in Chapter 7, in order to properly value a business based on cash flows, we need to first establish the appropriate cash flows to value—the unlevered free cash flow (UFCF). Once we have properly calculated UFCF we can project and discount the cash flows to present value (PV). We then estimate a terminal value, which is a representation of the value of the business after the last projected year. The sum of the present values of each cash flow is added to the PV of the terminal value to give us the total value of the business.

MID-YEAR VS. END-OF-YEAR CONVENTION

The formula to calculate PV is UFCF × (1 + DiscountRate)period. When discounting cash flows in valuation, there are two methods to determine the period: the mid-year convention and the end-of-year convention.

The end-of-year convention assumes each cash flow is discounted at a full year. Year 1 is discounted by one full year, Year 2 by two full years, and so on.

The mid-year-convention discounts each cash flow by half a year. Year 1 is discounted by half a year (0.5), Year 2 by 1.5 years, and so on. The concept here is we don’t know exactly when these cash flows come in. Technically, if the end-of-year convention is used where we discount the cash flows by one year in full, we are assuming the cash flow has come in one lump sum at the end of the year. The mid-year convention ...