Chapter 2 of 6
DCF: cash-flow definitions, terminal value and sensitivity
Build a small discounted-cash-flow model with consistent capital claims and an explicit terminal assumption.
In this chapter
Match FCFF with all capital and FCFE with equity #
Unlevered FCFF is commonly discounted at an appropriate weighted average cost of capital to estimate operating enterprise value. FCFE is commonly discounted at a cost of equity to estimate equity value. Definitions and adjustments must align.
Subtract relevant debt and other senior claims and add eligible non-operating assets when bridging enterprise to equity. Do not subtract debt again from an already equity-cash-flow valuation.
Forecast the reinvestment required for growth #
Cash growth requires a business mechanism: volume, price, margins, working capital and capex. High growth paired with no incremental investment often needs an explanation.
Use a finite explicit forecast and a justified later phase. The terminal phase cannot assume that an immature business grows faster than its economic environment indefinitely without confronting the consequences.
Read the perpetual-growth denominator #
A simplified terminal value is next-period sustainable cash flow divided by discount rate minus long-run growth. The discount rate must exceed that growth assumption in this model.
The difference between the two rates can dominate value. A small denominator magnifies model risk. An exit-multiple terminal approach replaces one assumption with another; it does not eliminate uncertainty.
Show how much value comes from the distant future #
Report the share of present value coming from the terminal term and a sensitivity grid for required return and growth. Compare an adverse case with lower operating cash and more reinvestment.
Check timing, units and whether cash is discounted at year-end or another convention. Round final estimates sensibly. A target chosen first and justified with a tuned terminal rate is not independent research.
Hypothetical worked example
A fictional DCF you can calculate
Suppose unlevered cash is ₹10 crore at the end of each of years one and two, discount rate 10%, and zero perpetual growth thereafter with ₹10 crore sustainable annual cash. Terminal value at year two is 10/0.10 = ₹100 crore.
Present enterprise value is 10/1.10 + (10+100)/1.10² = about ₹100 crore. With ₹20 crore net debt and no other adjustments, illustrative equity value is ₹80 crore. These assumptions deliberately make the arithmetic simple.
Common mistakes
- Discounting equity cash at an all-capital rate without reconciliation.
- Using perpetual growth at or above the discount rate.
- Subtracting debt twice.
In an FCFF valuation, what does the discounted operating cash flow estimate before the equity bridge?
Make this chapter useful
Can you defend the reasoning?
Before moving on, answer the self-check in your own words and write why each alternative fails. Use the worked example to test that explanation. Then apply it in the module research task; keep the assumptions and the evidence that could change your answer.
Desk assignment
What to submit
Build a two-stage DCF, enterprise-to-equity bridge and sensitivity grid; state the terminal-value share and what breaks the model.
Use the research ledger for dated evidence, or the module workbooks for calculations. Separate observations, assumptions and interpretation.
Sources and further reading
- NISM: Research Analyst learning topics (scope reference; independent lessons) ↗
- NSE: company integrated financial filings ↗
Further-reading references from the curriculum source list. Contract sizes, expiry calendars, settlement references, margin parameters and tax treatment can change; verify the current operative documents for the actual product. Worked figures are illustrative, not current quotes.
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General financial education. No securities recommendation, assured outcome or personal advice. Read the risk disclosures.