Question

3. How do you determine the value, using discounted cash flows, of a company that pays no dividends (as in a company that is in the early stages of growth)? What cash flows are discounted (in detail) and at what discount rate(ie. How is such rate calculated, not what is the number)?

Answer 1

When a company is not paying any dividends, the value is calculated by simply applying the discount rate on the projected cash flows from operations after tax.

While discounting, one has to calculate the profit after tax for the company for each of the years and then add back all the non cash elements of the expenses in the following manner:

Revenue from operations: XXXX

Add: Other revenue       : XXXX

Total Revenue              : XXXX

Less: Expenses:         : XXXX

(Total of all expenses)

Net profit before tax     : XXXX

Less: Tax @ X%         : XXXX

Profit after tax            : XXXX

Add: Non-Cash Expenses

Depreciation & Amortization : XXXX

(Add back any other similar expenses which do not involve any outflow of cash)

Cash Flows after tax : XXXX

Generally, this cash flow is discounted by the Weighted Average Cost of Capital of the company. It is calculated as follows:

Cost of equity X Equity/(Equity+Debt) + Cost of debt X Debt/(Equity+Debt)

Cost of Equity

Capital Asset Pricing Model is used to calculate the cost of equity in the following manner;

Where:

Where:

E(R_i) = Expected return on Equity

R_f = Risk-free rate of return

β_i = Beta of asset i

E(R_m) = Expected market return

E(R_i) = R_f + β_i * [E(R_m) – R_f]

Cost of Debt:

After tax cost of debt :

Cost of Debt x (1 – Tax Rate)