The Discounted Cash Flow (DCF) valuation method is a fundamental approach to estimating a company's intrinsic value based on its expected future cash flows. This guide provides a detailed step-by-step solution to the TechVision Inc. valuation case study, ensuring even beginners can understand the concepts of cash flow forecasting, discounting, and financial modeling.
1. Understanding Free Cash Flow (FCF) Projections
Free Cash Flow (FCF) represents the amount of cash available to a company’s investors after covering operating expenses and capital expenditures (CAPEX). The standard formula for FCF is:
Show Free Cash Flow Formula
FCF = EBIT × (1 - Tax Rate) + Depreciation - CAPEX - Change in Net Working Capital
Using the assumptions from the case study, let's calculate TechVision Inc.'s projected FCF for the next five years:
| Year |
Revenue ($M) |
EBIT ($M) |
Depreciation ($M) |
CAPEX ($M) |
Change in NWC ($M) |
FCF ($M) |
| 2024 |
740 |
163 |
30 |
(43) |
(20) |
110 |
| 2025 |
829 |
182 |
33 |
(47) |
(25) |
120 |
| 2026 |
928 |
204 |
37 |
(51) |
(30) |
130 |
| 2027 |
1039 |
229 |
41 |
(56) |
(35) |
140 |
| 2028 |
1164 |
257 |
47 |
(61) |
(40) |
150 |
Each year, the free cash flow grows as revenues increase and TechVision efficiently manages costs.
2. Calculating the Discount Rate (WACC)
The Weighted Average Cost of Capital (WACC) represents the required return from both debt and equity investors. It accounts for the company’s cost of equity and cost of debt, weighted by the proportion of financing sources.
Show WACC Formula
WACC = (E / (E + D) × Re) + (D / (E + D) × Rd × (1 - Tax Rate))
Where:
- Re (Cost of Equity): Calculated using the Capital Asset Pricing Model (CAPM).
- Rd (Cost of Debt): The company's interest rate on debt.
- E: Market value of equity.
- D: Market value of debt.
Show CAPM Formula for Cost of Equity
Re = Risk-Free Rate + Beta × Market Risk Premium
Plugging in the case study values:
- Risk-Free Rate: 3.5%
- Equity Risk Premium: 6%
- Beta: 1.3
Re = 3.5% + (1.3 × 6%) = 11.3%
Assuming TechVision's capital structure consists of 70% equity and 30% debt with a pre-tax cost of debt of 5.5%, WACC is:
WACC = (0.7 × 11.3%) + (0.3 × 5.5% × (1 - 25%)) = 9.2%
3. Calculating Terminal Value
Beyond the forecast period, we estimate TechVision’s value using the Gordon Growth Model:
Show Terminal Value Formula
TV = (FCFfinal year * (1 + g))/ (WACC - g)
Assuming:
- Perpetual Growth Rate (g): 3%
TV = (140.03 * (1 + 3%)) / (9.2% - 3%) = $2.34622 billion
4. Discounting Cash Flows to Present Value
To determine TechVision’s intrinsic value, we discount all projected cash flows to their present value:
Show Present Value Formula
PV = FCFt / (1 + WACC)t
Discounted TV = 2346.22 / (1 + 9.15%) = $1.51461 billion
Summing the discounted values, we calculate:
- Present Value of FCFs: $425.89M
- Present Value of Terminal Value: $1.51461 billion
Enterprise Value (EV) = $1.9405 billion
5. Sensitivity Analysis
Both WACC and the terminal growth rate (g) feed directly into the Terminal Value formula, so small changes in either assumption can move Enterprise Value by a large margin. Using the same five-year FCF projections and the Gordon Growth Model above, recomputing Enterprise Value across a range of WACC and terminal growth assumptions gives:
| WACC | g = 2.0% | g = 2.5% | g = 3.0% |
|---|
| 8.0% | $2,248M | $2,415M | $2,616M |
| 9.0% | $1,920M | $2,036M | $2,173M |
| 9.2% (base case) | $1,865M | $1,974M | $2,101M |
| 10.0% | $1,673M | $1,758M | $1,856M |
Two things stand out from this table:
Terminal growth rate changes matter, but less than WACC changes. Holding WACC constant at 9.0%, moving the terminal growth assumption from 2.0% to 3.0% — a 100 basis point change — increases Enterprise Value from $1,920M to $2,173M, a swing of about 13%. That's a meaningful move for what looks like a small, easy-to-overlook input.
WACC changes matter more than terminal growth rate changes. Holding the terminal growth rate constant at 3.0%, moving WACC from 8.0% to 10.0% swings Enterprise Value from $2,616M to $1,856M — a difference of roughly 41%. The discount rate compounds its effect across both the explicit forecast period and the terminal value, while the terminal growth rate only affects the terminal value's denominator (WACC − g).
This asymmetry is exactly why interviewers ask candidates to build sensitivity tables in the first place: it shows which assumption you should spend the most time defending. In this case, the WACC estimate — driven by beta, the risk-free rate, and the capital structure weights — deserves more scrutiny than the terminal growth assumption, since it moves the valuation roughly three times as much per unit of change. For a deeper walkthrough of comparing these two levers side by side, see Sensitivity Analysis: WACC vs. Terminal Growth Rate.
Conclusion
This detailed DCF analysis provides insights into how future cash flows drive intrinsic valuation. By adjusting growth rates, discount rates, and WACC assumptions, investors can refine their estimates and improve decision-making.
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