Demystifying Valuation: A Comprehensive Guide to the Discounted Cash Flow (DCF) Approach

Part-03

In the previous edition, we explored essential concepts of the Discounted Cash Flow (DCF) approach, including Net Operating Profit After Tax (NOPAT) and Net Capital Expenditure. We examined how NOPAT provides an robust measure of a firm's operating performance, while Net Capital Expenditure reflects capital investments beyond depreciation. These foundational elements are crucial for understanding the computation of Free Cash Flow. In this edition, we will build upon these principles to further enhance your understanding of the DCF model.

16. Explain the tax rate used in the computation of Free Cash Flow (FCF).

The tax rate used in the computation of Free Cash Flow (FCF) can be classified into two types: the marginal tax rate and the effective tax rate. The marginal tax rate refers to the rate of tax applicable to the firm based on its taxable income, which varies according to the tax laws of the country. On the other hand, the effective tax rate is calculated as the ratio of the firm’s total tax payable to its taxable income.

The difference between the marginal tax rate and the effective tax rate arises due to variations between accounting principles and tax laws. Certain expenses that are deductible under tax laws may not be allowed under accounting principles, and vice versa. For example, some forms of depreciation may be treated differently for tax purposes compared to accounting standards. Furthermore, tax exemptions, credits, or deductions can also contribute to the disparity between these two tax rates.

For the DCF approach, the marginal tax rate is typically used, assuming no significant changes in tax rates in recent years. The marginal tax rate reflects future tax obligations more accurately since it directly relates to the firm’s taxable income at the current applicable rate.

However, when a firm is experiencing operating losses, it is appropriate to use the effective tax rate instead of the marginal tax rate. For example, if a firm has a taxable income of ?1,00,00,000 and a tax payable of ?10,00,000, its effective tax rate would be 10% (?10,00,000 ÷ ?1,00,00,000), even if the statutory marginal tax rate is 30%.

Additionally, when estimating the terminal value of a firm, the marginal tax rate is the most appropriate rate to use. This is because, over the long term, the differences between the marginal and effective tax rates tend to diminish, with the effective tax rate eventually converging towards the marginal tax rate.

For example, a firm might have a marginal tax rate of 30% and an effective tax rate of 15% in the short term due to various tax credits. However, in the long term, as tax credits are utilized or expire, the effective tax rate will converge to the marginal rate, making the marginal rate the more appropriate measure for terminal value calculations.

17.?? Illustration on the computation of Free Cash Flow (FCF) value under the DCF approach

18. Is there an alternative truncated approach to measure Free Cash Flows? Yes, an alternative and simplified approach to measure Free Cash Flow (FCF) involves deducting the firm's estimated reinvestment needs from its Net Operating Profit After Tax (NOPAT). In this approach, FCF is calculated as:

FCF = NOPAT - Estimated Reinvestment Needs (E)

Where E represents the estimated reinvestment needs of the firm. This method offers a streamlined approach, particularly in cases where full, detailed calculations of capital expenditures and working capital are less critical.

For example, if a firm's NOPAT is ?50,00,000 and the estimated reinvestment needs are ?20,00,000, the Free Cash Flow (FCF) would be:

FCF = ?50,00,000 - ?20,00,000 = ?30,00,000

This truncated method simplifies the FCF calculation by focusing only on reinvestment needs.

19. How do you estimate the reinvestment needs of a firm? The estimation of a firm’s reinvestment needs is a function of two main variables: estimated net capital expenditure and estimated changes in non-cash working capital.

For instance, if a firm’s estimated net capital expenditure is ?15,00,000 and its estimated increase in non-cash working capital is ?5,00,000, the total reinvestment needs would be:

Reinvestment Needs = ?15,00,000 + ?5,00,000 = ?20,00,000

Thus, the total estimated reinvestment needs reflect the investments in long-term assets and the additional working capital necessary to sustain the firm’s operations.

20. How is Net Capital Expenditure Estimated?

In practice, firms rarely experience smooth or consistent capital expenditure patterns. This variability can be effectively managed by normalizing the capital expenditures from previous periods and employing appropriate statistical techniques, such as univariate time series forecasting models, to estimate the firm’s future capital requirements.

For example, if a firm has experienced capital expenditures of ?10,00,000, ?12,00,000, and ?9,00,000 over the past three years, the average capital expenditure could be normalized to ?10,33,000. This trend can be projected forward using time series forecasting to estimate future capital needs.

In cases where historical capital expenditure data for a firm is unavailable, it is advisable to rely on the average capital expenditure of the industry, provided there is no significant variation in the capital requirements among individual firms within the industry. For instance, if the industry’s average capital expenditure is ?15,00,000, this figure may be used as a proxy, assuming that the firm’s capital requirements are consistent with industry standards.

By normalizing and projecting past data or using industry averages in the absence of firm-specific data, firms can arrive at a reasonable estimation of their future capital expenditure requirements.

In this edition, we explored alternative methods to measure Free Cash Flow, the estimation of reinvestment needs, and approaches for calculating Net Capital Expenditure. These foundational concepts are crucial for accurate business valuation. Stay tuned for the next edition on 10th September 2024 for further insights.