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Author: TMFSandman Big red star, 1000 posts Feste Award Nominee! Old School Fool Coverage Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 1670  
Subject: Re: debt Date: 8/5/2012 11:30 AM
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Personally I start with operating income (before interest income or interest expense is factored in), find the present value of the free cash flow based on the operating earnings, then add cash and subtract debt from that figure.

Whether or not you add cash and subtract debt to your discounted cash flows depends on what number you start your valuation out with.

If you start with net income, the value of cash and debt are already included: interest income and interest expense have already been added and subtracted from operating earnings. If you took net income and grew it out into the future and discounted it back, and then added cash and subtracted debt to the discounted present value, you would be factoring in cash and debt twice.

Now, if you start your DCF with operating income, which is before interest from cash is added and interest on debt is subtracted, then you should add the total amount of cash and subtract the total amount of debt from your discounted present value.


It's best to show this with a simple example:

If you start your DCF with net income (which includes interest income) and then add the cash that was used to generate this income to the discounted present value you found, it would be like saying the present value of a 5 year, $10,000 CD earning 3% with a 3% risk free rate is the sum of the beginning principal PLUS the present value of the discounted future interest payments:


Year 1 2 3 4 5
int. and prin. $10,300 $10,609 $10,927 $11,255 $11,593
interest $300 $309 $318 $328 $338
PV interest $291 $291 $291 $291 $291


sum of 5 years of discounted future interest payments: $1,456
sum of $10,000 principal and disc. future interest payments: $11,456

And this clearly can't be the case: the present value of $10,000 can't be $11,456, but if you find a bank that thinks otherwise, IM me. :)

You might ask, if you should only do one or the other, why $1,456 is not equal to $10,000. It will be, once we add back in the discounted present value of the $10,000 in principal we'll get back from our CD 5 years from now:

$10,000/1.03^5 = $8,626
$8,626 + $1,456 = $10,082 (well, that's what I get for rounding)


Think of the discounted return on principal from the CD as the terminal value part of your DCF. Just like the CD example, a large part of the value lies in the terminal value.



Mike
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