A corporate finance conundrum
Posted by Arun Uday on September 24, 2007
Ok, so you think you are a finance pro. Then answer this valuation puzzle -
Suppose you are trying to value a firm. You do a DCF for the Free Cashflows to the Firm (FCFF), which means, you leave out any financing charges such as interest payments. So, at the end of the exercise you arrive at the Enterprise Value of the firm. How do you now handle the cash that the firm has on the balance sheet? Do you add it to your above computed value, subtract it or leave it alone? (For argument’s sake lets assume that the firm really has a lot of cash sitting on its balance sheet).
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Anuj said
I would guess that the cash needs to be added back (logically, cash in company should increase the value of the company isn’t it?)
Finance Pro said
According to the discounted cash flow valuation model, the intrinsic value of a company is the present value of all future free cash flows, plus the cash proceeds from its eventual sale. Cash on B/S at the point of valuation is viewed in conjunction with the rest of the B/S elements then(particularly Current Liabilities and obligatory payables) when determining cash proceeds from such an eventual sale. Thus, Cash on B/S is not added back in toto but is treated to arrive at the net sale value of the enterprise and such value is added to the Enterprise value determined from the FCFF’s. Trust this solves your conundrum…
Aanchal said
I would think that you leave the cash alone because the EV is the present value of all future cash flows…and the future cash flows are estimates of what the assets(inlc.cash) of the business can generate…so the EV already accounts for the cash that the business holds.
Also EV = present value of future cash flows and at market value equals the total assets of the company.
Aviral Jain said
I think the value of the enterprise derived from the DCF will always be on a operating basis – so it should not include the value of excess cash (non-operating in nature) taking the fair value premise; however if the purpose of the valuation is to determine the value of the firm (equity) it should include the value of cash and other non-operating assets.
Shrinivas Tapadia said
Valuation is going to be on the basis of a going concern. That implies whatever your balalce sheet shows in curret is going to be used for generating future cash flows. Now it has a simple implication that in this case cash cannot be added back.
The value arrieved at using Entreprize value is a notional figure which is based on future performance and not on current performance. So current is already factored in. Thats how time value of money works. And I think that also solves your conundrum..
Lake Falconer said
You need to ascertain whether the cash on the balance sheet is surplus, or whether it is needed in working capital terms to fund the trading that your DCF pattern is based on. If the business is self sustaining and the cash is all surplus – possibly as the residue of past profits – then you can add it all back. Converesly if all the cash is needed to fund short term losses, or investments in stock and debtors then it should not be adjusted for.