Business Valuation Free Cash Flow Method

How to determine the value of a business or project using the free cash flow method. For more information visit www.calgarybusinessblog.com

---

Closed Caption:

hello this is matt from Calgary business
blog in this is a brief tutorial on
business valuation or project evaluation
using the cash flow free cash flow
method first thing that I want to go
over is this hypothetical scenario that
i constructed it's a hospital that wants
to determine if constructing a new
outpatient orthopedic surgery center is
a profitable operation their current
facility offers some of the same or the
same procedure with older technology and
it requires an overnight stay
so there will be some cannibalization of
their own business and there will be
some cost savings so this is a good
example because it demonstrates some of
the complexities of accurately
predicting free cash flows the key here
is to do a flow of cost and flow of
revenues analysis in order to determine
how costs and revenues will be affected
by this new project or business so here
we've got our likely scenario we can say
that it was determined by the higher-ups
as you can see 14 procedures per day
6,000 procedure price per procedure
allowances for bad debt 40-percent etc
etc and here we've got reduction in
pacing costs and loss of inpatient
revenues so the this highlights the
example of having to follow the flow of
cost and flow of revenues now the first
thing that you're going to need to do is
estimate the cost of capital and this
was demonstrated how to do this in a
previous video now you'll notice the
spreadsheet is constructed much like and
income statement that this is a common
way of doing it and is is really quite
handy except for the income statement
will end at earning earnings before inc
interest and after taxes
this is because of the basic business
valuation rules which say we do not
deduct interest these rules can be found
on calgary business blog so the first
thing we want to do is determine our
ears 0 costs so here we've got our
building QWOP costs and our equipment
costs one thing that is often omitted or
four got is the opportunity costs so in
this case it's the sale of the land that
they are building this new facility upon
this cost and should be included in your
business valuation and now down again
we've got our capital expenditures which
is just an addition of our building
construction costs and our investment in
working capital which we will say is
thirty percent of the year one supplies
that's just the supplies on hand at the
beginning of the year that we will want
to have now here's another thing that I
wanted to highlight how the company
accounts for supplies will affect how
you value the business
this company is using the last in first
out method and i will explain that a
little bit more in the low later
so here we have our net cash flows for
year zero now our sales will simply be
number of procedures times price times
days in operation this will be adjusted
in year 2 and on by the inflation rate
and the growth rate these are both
assumptions are fixed costs pretty
straightforward i arbitrarily made these
fixed costs and they will be adjusted by
inflation now our variable costs these
will be a little bit different because
we've got our loss of inpatient revenue
and our reduction in inpatient costs
again this is to highlight how you must
do a flow of cost and flow revenue
analysis to see how it affects its
existing business if it does not affect
existing business while you're good to
go you don't need to go over this stuff
you can see the loss of impatient
revenue is twenty percent of sales and
our reduction in inpatient costs is
fifty percent of the loss in inpatient
revenues and this summed up gives our
total variable cost and these are just
adjusted for inflation and growth rate
and that brings us down to edit .
earnings before income taxes
depreciation and amortization and that
is simply our sales minus our total very
variable costs and total fixed costs and
now we've got depreciation we have to-
that from a bit . in order to determine
what our tax rate will be and that is
because depreciation is essentially
attack shield now you will have to check
with the accounting department to
determine what form of depreciation that
the it's not all companies use
straight-line depreciation as you can
see here and so our learnings before
interest and taxes is simply our Abbot
da- our depreciation and this will give
you our tax rate which is our edit times
our tax rate
and now we have our earnings before
interest and after taxes
we're going to want to add and you can
see this is kind of where income
statement like spreadsheet ends so now
what we're going to want to do is we're
going to want to add depreciation back
onto our cash flows because depreciation
is not a cache expense and this is where
we come back to our investment in
working capital you can see here that we
started off with thirty percent of our
supplies in year one we bought one
hundred percent of the supplies so this
essentially carries over 30-percent into
the next year but because we use the
last in first out
accounting method we will have to adjust
that cost by the inflation rate and over
the next year's it will be adjusted for
growth and inflation so this just
highlights another example of where
common online tutorials miss out on the
subtleties of the free cash flows
evaluation method and so down here we
have our net cash flows and these are
simply our FB @ + artist depreciation
expense and minus our investment in
working capital that goes through all
the way to your six so now we've got to
determine whether this project is a
ongoing concern or if it terminates so
let's assume it will terminate in year 5
at first so then it is simply a discount
of cash flows to present value terms
plus the initial investment that's just
how you have to do it in Excel and we
get a net present value
now if we consider the business a going
concern meaning a perpetuity with no
growth we calculate that value by taking
the year 6 value and divide it by your
risk-adjusted weighted average cost of
capital and then you convert that into
present value terms now considering the
considering it as a perpetuity with the
growth again that's the year 6 discount
Kath Arctic net cash flows and you
divide that by the difference between
the weight adjusted cost of capital or
risk adjusted cost of capital and your
growth assumption so that's essentially
. 09 676 minus point 05 to give you four
point zero point zero 476 and then you
adjust that for present value terms and
you can see here that the vast majority
when considered a perpetuity of the
value of the business is after year six
so you have to determine whether these
assumptions are correct is it going to
just go on forever making those streams
of cash flows is that a valid assumption
and then it's common to do a sensitivity
analysis after this adjusting the
procedures per day and assigning
percentage values like a sixty percent
chance that it'll move down to seven
procedures per day etc etc and then you
can create analysis like those adjusting
for the probability of declining cash
flows or declining procedure from
declining procedures cetera so that's
the tutorial on the business valuation
model using the free
cash flows method hope this helped hope
it was a bit different than the other
tutorials you see out there showing some
of the subtleties and the traps that
commonly people fall into okay thanks