Discounted free cash flow

Nevertheless, nowadays the maximization of the shareholder s value (SHV) seems to be the main priority of the firms and what really drives their decisions. The use of SHV as the objective to be maximized is mainly motivated by the fact that it reflects in a rather accurate way the capacity that the company has to create value. The SHV of the firm can bee indeed improved by maximizing its CV. According to Weissenrieder (1998), the market value of a company is a function of four factors (i) investment, (ii) cash flows, (iii) economic life, and (iv) capital cost. Specifically, this model applies the discounted-free-cash-flow method (DFCF) to compute the CV of a company. 

The Discounted-Free-Cash-Flow Method (DFCF)... 

The framework suggested in this book is thus in consonance with the new trends in PSE, which are going toward an enterprise wide optimization framework that aims to integrate all the functional decisions into a global model that should optimize an overall key performance measure. Here, it is proposed the corporate value measured through the discounted free cash flow method as a suitable first approach to this posed requirement. 

Quarter Profit after sales A Accounts receivable A Accounts payable Net investment Other expenses Change in invested capital Discounted free cash flows... 

Sum of discounted free cash flows at the end of the planning horizon Exogenous cash in period t... 

It is given a set of existing products and a set of potential products. Failure to pass clinical trial implies termination of the development project. The clinical trial for each new product trial has a probability of success, an associated duration and cost, which are assumed to be known. On the SC side, it is assumed that various items of technological equipment are available to be installed in existing and potential facility sites. Regarding the financial area, the formulation endeavors to model cash management and value creation. To calculate corporate value (CV) the discounted-free-cash-flow (DFCF) method is utilized. 

Similarly to the Design-planning formulation, the financial formulation follows that presented in Chap. 2 (Eqs. (2.29)-(2.60)). Such formulation uses the discounted-free-cash-flow (DFCF) method in order to carry out the firm s valuation. Again, the formulation has been extended to consider the different scenarios associated with clinical trial outcomes by adding the extra index g to each variable. However, some modifications are required to incorporate the costs of development projects (RDcostirjictg, ei,c)tg) and some equations must be included so as to calculate the expected CV as well. This set of modified and new equations are described next. 

In the strategy presented in this chapter the method of discounted free cash flow (DFCF) method is applied to assess the decisions undertaken by a Arm. The DFCF method calculates the enterprise value by determining the present value of its future cash flows and discounting them taking into account the appropriate capital cost during the planning horizon defined (Grant 2003). 

Usually, the following two economic indicators are used to assess the effectiveness of an investment Net present value (NPV) and internal rate of return (IRR). In practice, it is difficult to compare different investments on the basis of only one indicator because NPV depends on the value of investments (not comparable for two investments with different initial values) whereas IRR value is determined at the end of the project. Additionally, NPV is sensitive to the assumed discount rate in contrast IRR is independent of the value of the initial investment and independent of the discount rate. A financial profile can be prepared for NPV which shows a very good return on the investment process over the period. Since cash flows were calculated according to the free cash flow for the firm (FCFF) formula, no financial costs were included. 

The best w ay to evaluate free enterprise projects is to use discounted cash flow (DCF) rate of return, sometimes called internal rate of return. 

Certainty equivalent approach (Keown etal., 2002) In this approach a certainty equivalent is defined. This equivalent is the amount of cash required with certainty to make the decision maker indifferent between this sum and a particular uncertain or risky sum. This allows a new definition of net present value by replacing the uncertain cash flows by their certain equivalent and discounting them using a risk-free interest rate. 

For example, consider a 10-year government bond denominated in euros with an 8% coupon rate. Suppose that coupon payments are delivered semiannually and the annual spot rates are shown in the fourth column of Exhibit 3.4. The third column of the exhibit shows the cash flow every six months. The last column shows the present value of each cash flow discounted at the corresponding spot rate. The total in the last column is the arbitrage-free value of the bond, 115.2619. 

To see the significance of the second drawback, it is useful to partition the value of an option-free floater into two parts (1) the present value of the security s cash flows (i.e., coupon payments and matnrity value) if the discount margin equals the quoted margin and (2) the present value of an annuity which pays the difference between the quoted margin and the discount margin mnltiplied by 100 and divided by the number of periods per year. 

Here each premium P is calculated on the notional amount and multiplied by its appropriate daycount fraction. The resulting cash flow is then discounted at the risk-free rate and finally multiplied by its survival probability, that is, the probability that the relevant preminm payment will actually take place, since in the event of a default all future premium payments will be cancelled. 

Carleton and Cooper (1976) describes an approach to estimating tetm structure that assumes default-free bond cash flows, payable on specified discrete dates, to each of which a set of unrelated discount factors are applied. These discount factors are estimated as regression coefficients, with the bond cash flows beir the independent variables and the bond price at each payment date the dependent variable. This type of simple linear regression produces a discrete discount fimction, not a continuous one. The forward-rate curves estimated from this fimction are accordir ly very ja ed. 

All bond instruments are characterized by the promise to pay a stream of future cash flows. The term structure of interest rates and associated discount function is crucial to the valuation of any debt security and underpins any valuation framework. Armed with the term structure, we can value any bond, assuming it is liquid and default-free, by breaking it down into a set of cash flows and valuing each cash flow with the appropriate discount factor. Further characteristics of any bond, such as an element of default risk or embedded option, are valued incrementally over its discounted cash flow valuation. 

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