Saito Solar-Discounted Cash Flow Valuation
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Saito Solar CaseTeam 5 – Yuhan Jiang, Wenning Tang, Mingkun Yao, Shangyu Zhang, Jianghao ZhuDate: 07/05/2017Using a DCF approach, why are projected free cash flows, rather than profits, used in estimating the value of the firm?DCF approach is a valuation method that valuing a company by forecasting its future cash flows. Then, the NPV of the company can be calculated by discounting all the future cash flows. Projected free cash flows represent how the company will perform in dollars and the amount of cash the company can generate after considering the change in net working capital, capital expenditure, and depreciation effect on the value of company. However, profits do not consider above factors that can affect the value of a company. Profits mean the earnings of a company. It is an accounting value based on accounting rules, but it does not mean that the company generates the same amount of cash value. Therefore, projected free cash flows are more suitable to estimate the value of the company. What is the role of WACC in valuation?Weighted Average Cost of Capital (WACC) is a way to calculate the cost of capital of a company based on proportionately weight of each category of capital, such as common stock, preferred stock bonds, long-term debt and other sources of capital. When evaluating investments, securities analysts use WACC as a tool to help them calculate which investment is more valuable. In a DCF approach, analysts use WACC to discount the future free cash flow and terminal value to get the net present value of a specific investment or business. On the other hand, for investors, WACC is the minimum return rate for them. When the return of a company is less than its WACC, the investors will stop their investments in the company.Based on Mr. Suzuki’s estimate of 3 – 5% growth rate of Saito Solar’s free cash flows over the next 20 years, how much would Saito Solar be valued at? The owner’s required rate of return was 10%.Table 1[pic 1]Mr. Suzuki does not agree with Mr. Yoshida in unchanged free cash flow over next 20 years and he believes free cash flow will grow 3%-5% each year, since he is prettyoptimistic about the impact of current policy change. Since time values money, business value should not be calculated by simply sum up its future cash flows. Instead, each year’s cash flow should be discounted at a discount rate. When it comes to discount rate, which is cost of capital for the firm, Saito Company has no debt, thus it discount rate should be required return of owner, which is 10%. By assume different growth rate from 3%-5%, we can get three different versions of 20 years’ cash flows. Then, we discount these cash flows to get their net present value or business value, which are $2692.07 at 3%, $2923.15 at 4%, $3180.69 at 5%.
How do you estimate firm value when free cash flows of the firm are uneven for the first few years, but stay constant thereafter?When the firm’s free cash flows are not even at first few years we can use DCF model to discount its future cash flow in first years to the firm’s value, which is the sum of each year’s cash flows discounted by WACC. And then when the firm’s cash flow becomes constant, we change the method to a perpetuity method. Because each firm established, it is considered as going concern. When a firm has a constant cash flow, we can treat the cash flow as perpetuity. So when we estimate the firm’s value in this way, we only need to get its constant cash flow and its WACC, which is easy and feasible. Based on the free cash flow forecast provided in Appendix 3 of the case and assume a range of 9 – 11% WACC and 1 – 3% terminal value growth rate, what is the range of values for Saito Solar?Table2 [pic 2][pic 3]Table3[pic 4]Unlike other two partners, Mr. Saito does not believe that the cash flow will grow at a constant rate for 20 years and company will stop generate cash flow after 20 years. Instead, he believes that the policy change will result in sharply growth over next few years and the company will have a infinite life span. Thus, he projects next five-year free cash flows. By using growth rate and year 5 cash flow, we can calculate the cash flow at terminal year. We can get capitalization rate by using WACC less terminal growth rate. Then, we can get terminal value at year 5 by using cash flow at terminal year divided by the capitalization rate. Last step, discounting 5 years’ cash flows and terminal value by WACC, and sum those present values up to get the business value. Since WACC and terminal growth rate are in ranges that are 9 – 11% and 1 – 3%, we create a data table to simulate business value under different conditions as shown in table 3.