DCF Valuation for the IBBI Valuation Exam
Match the cash flow to the rate, then watch the terminal value: that is where DCF marks are won or lost.
Discounted cash flow (DCF) values a business as the present value of the cash it is expected to generate: cash flows for an explicit forecast period, plus a terminal value for everything after. ICAI Valuation Standard 103 calls it one of the most common methods for shares, businesses, real estate projects and debt instruments.
For the Securities or Financial Assets exam, DCF is the method most likely to appear inside a case study. The arithmetic is simple; the marks are lost on consistency: matching the cash flow to the discount rate, and growing the right year's cash flow into the terminal value.
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The DCF Method Step by Step
The sequence ICAI VS 103 (para 57) sets out, in plain words.
- 1
Take the projections
Profit and loss, balance sheet and cash flow forecasts with their assumptions. Where the balance sheet is missing, capex and working-capital plans can suffice.
- 2
Test them for reasonableness
Ratio and trend analysis against history. Using management's projections does not make the valuer a party to them (para 66).
- 3
Choose the cash flow
Pre-tax or post-tax, free cash flow to firm (FCFF) or free cash flow to equity (FCFE). Add back depreciation and other non-cash items, deduct capex and incremental working capital.
- 4
Set the discount and terminal growth rates
The discount rate must match the cash flow chosen (see the table below).
- 5
Discount and add up
Present value of explicit-period cash flows plus present value of the terminal value. Under FCFF this gives enterprise value; deduct debt and debt-like items to reach equity.
Match the Cash Flow to the Rate
FCFF
Belongs to
All capital providers: equity, preference and lenders
Discount at
WACC
Result
Enterprise value
FCFE
Belongs to
Equity shareholders only, after interest, preference dividend and debt flows
Discount at
Cost of equity
Result
Equity value
Pre-tax cash flow
Belongs to
As above, before tax
Discount at
Pre-tax rate
Result
Same as post-tax, if done consistently
| Cash flow | Belongs to | Discount at | Result |
|---|---|---|---|
| FCFF | All capital providers: equity, preference and lenders | WACC | Enterprise value |
| FCFE | Equity shareholders only, after interest, preference dividend and debt flows | Cost of equity | Equity value |
| Pre-tax cash flow | As above, before tax | Pre-tax rate | Same as post-tax, if done consistently |
Worked Example: Three-Year DCF
Illustrative figures, ₹ crore. FCFF of 100, 110 and 120 in years 1-3; WACC 12%; terminal growth 5%; net debt 300; 10 crore shares.
PV of year 1
Working
100 × 0.8929
₹ crore
89.29
PV of year 2
Working
110 × 0.7972
₹ crore
87.69
PV of year 3
Working
120 × 0.7118
₹ crore
85.41
Terminal value at end of year 3
Working
120 × 1.05 ÷ (0.12 − 0.05)
₹ crore
1,800.00
PV of terminal value
Working
1,800 × 0.7118
₹ crore
1,281.20
Enterprise value
Working
Sum of the PVs
₹ crore
1,543.60
Equity value
Working
1,543.60 − 300 net debt
₹ crore
1,243.60
Value per share
Working
1,243.60 ÷ 10 crore shares
₹ crore
₹124.36
| Item | Working | ₹ crore |
|---|---|---|
| PV of year 1 | 100 × 0.8929 | 89.29 |
| PV of year 2 | 110 × 0.7972 | 87.69 |
| PV of year 3 | 120 × 0.7118 | 85.41 |
| Terminal value at end of year 3 | 120 × 1.05 ÷ (0.12 − 0.05) | 1,800.00 |
| PV of terminal value | 1,800 × 0.7118 | 1,281.20 |
| Enterprise value | Sum of the PVs | 1,543.60 |
| Equity value | 1,543.60 − 300 net debt | 1,243.60 |
| Value per share | 1,243.60 ÷ 10 crore shares | ₹124.36 |
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Terminal Value Carries Most of the Answer
In the example, the terminal value is 83% of enterprise value. Raise terminal growth from 5% to 6% and enterprise value moves from about ₹1,544 crore to about ₹1,771 crore. ICAI VS 103 (para 78) flags exactly this: a small change in the stable growth rate moves the value materially.
VS 103 lists four ways to set terminal value: the Gordon constant-growth model, a variable-growth model, an exit multiple (such as EV/EBITDA), and salvage or liquidation value for finite-life assets such as a mine. The explicit period should run long enough for the business to reach a steady state, a full cycle for a cyclical business such as cement, and the full life for a finite asset such as a BOT road project (para 67).
How the Valuation Examination Tests This
Expect a case study that gives three to five years of figures and asks for enterprise value, equity value or value per share across linked 2-mark questions (the case-study block carries 26 marks). The common traps: discounting FCFE at WACC, growing year 3's cash flow but discounting the terminal value with year 4's factor, forgetting to deduct debt to reach equity, and adding a control premium to a DCF value. VS 103 para 59 says DCF cash flows already reflect control, so no gross-up. Under 25% negative marking, a wrong 2-mark answer costs 0.5.
FAQs
What is the difference between FCFF and FCFE?expand_more
FCFF is cash available to all capital providers before debt service, discounted at WACC to give enterprise value. FCFE is what is left for equity after interest, preference dividends and net debt flows, discounted at the cost of equity to give equity value directly.
What is the mid-year convention in DCF?expand_more
It assumes each year's cash flow arrives in the middle of the year rather than at the end, so year 1 is discounted for half a year, year 2 for 1.5 years and so on. It gives a slightly higher value than the end-of-year convention. The Phase 6 syllabus names both.
Why is terminal value so large in a DCF?expand_more
Because it captures every year after the explicit period. For a business with an indefinite life it often makes up well over half the enterprise value, which is why the terminal growth rate needs the most support in the report.
Should a control premium be added to a DCF value?expand_more
No. ICAI VS 103 says DCF cash flows reflect the benefits of control, so the value is not grossed up for a control premium. A discount for lack of control may be needed when valuing a minority stake.
Next steps
- WACC and CAPMarrow_forward
- Comparablesarrow_forward
- DLOM and controlarrow_forward
- SFA mock testarrow_forward
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