Hi, how can you estimate a firm's enterprise value? The enterprise value is the value of the firm's underlying business, unencumbered by debt, and separate from any cash or marketable securities. To estimate a firm's enterprise value, we compute the present value of the free cash flow. Free cash flow is FCF for short. Free cash flow is what the firm has available to pay all investors including all equity holders and debt holders. We can estimate Free Cash Flow using the equation on this slide. In this equation, EBIT is Earning Before Interest and Tax, and T is Tax Rate. So EBIT times (1 = t) is Earning Before Interest. Depreciation is non cash expenses, but was deducted to get EBIT. So add it back to EBIT to estimate free cash flow. Capital expenditures are investments in fixed assets, and net working capital, also it is NWC for short, is the difference between current assets and current liabilities. That is, cash + inventory + accounts receivable - account payable. When sales increases, NWC also increases. As you can imagine that inventory and account receivables increase with the sales. We can define the firm's net investment as its capital expenditures in excess of depreciation. So net investment is equal to capital expenditures- depreciation. With that definition, we can also write the free cash flow formula as EBIT x (1-t)- net investment- increase in net working capital. We are going to use this formula to estimate free cash flow for Y. Since we haven't learned accounting terms in this free cash flow formula yet, the details of each accounting term will be discussed in the module for financial analysis. We are going to learn how to estimate a firm's current enterprise value by computing the present value of the firm's free cash flow. Let's take an example to learn how to find enterprise value using DCF model. First, we can find the value of a firm's free cash flows by discounting free cash flows by discount rate and sum the discounted free cash flows. Next, we can find the terminal value of a firm by assuming a constant long-run growth rate for free cash flows beyond year N. Here the long-run growth rate is typically based on the expected long-run growth rate of the firm's revenues. If Yonsei Corporation has the following expected future cash flows and the discount rate of 12%, what is your estimate of the value of Yonsei Corporation's stock in early 2016? You're going to learn how to estimate these future cash flows later. In the meantime, let's use these cash flows to find the enterprise value of Yonsei Corporation. What do you notice from these cash flows? They look similar to bond cash flows, don't they? The only difference is the cash flows of Yonsei Corporation are different from year to year. While the cash flows from bond are the same every year. These cash flows from year to year are different each other. We cannot find the present value of these cash flows at once using PV function. Instead, you can find the present value of each free cash flow and terminal value separately. Let's start Excel and estimate present value of 2016 FCF. Type in =PV. The first variable is interest rate. So type in 12% with this. For the number of periods type in 1. The third variable is payment amount, so type in 0. Future value is 25.1, so type in -25.1 or select C3. We can also specify the address of the cell including the future value. But you should type minus sign in front of the cell address to get the positive present value. The present value of 2016 FCF is 22.4. Let's find present value of 2017 FCF. Type in =PV and type in 12% for interest rate. For the number of periods, type in 2. For payment amount, type in 0. For future value, that is in cell D3. So select the cell which includes 27.9. Again you should put minus sign before cell address to get the positive present value. Then present value of 2017 FCF is 22.2. Repeat the same process for 2018, 2019, 2020, and 2021. I'll skip them but you should make sure that you get a present value for each future cash flows. Lastly let's find present value of terminal value. Again, type in equal PV and the first variable is interest rate, type in 12%. For the number of periods, type in 6. The third variable is payment amount, so type in 0. Future value is 506.7, so type in -506.7 or -H4, which include the future value. Then present value of Terminal Value is 256.7. Enterprise Value is the sum of present value of Free Cash Flows and present value of Terminal Value, that is $385. When you discount future free cash flow that will be paid to both debt and equity holders, you should use the firm's weighed average cost of capital as its discount rate. The firm's weighed average cost of capital is the average cost of capital the firm must pay to all its investors. In the previous example, the discount rate is the firm's weighted average cost of capital, and it is also called WACC for short. If the firm has no debt, then the weighted average cost of capital is equal to the cost of equity. But when a firm has debt, the WACC is on average of the firm's debt and equity cost of capital. In that case, the WACC is generally lower than the cost of equity because the cost of debt is generally lower than the cost of equity. Here we need to know this concept that the higher the risk, the higher the return. We all know that any project with higher risk, should have higher required return. If risk of your project does not provide XNT higher return, nobody will take riskier project. As we apply this concept to the cost of debt and equity. The cost of equity is higher than the cost of debt because equity holders require higher return than debt holders since equity is riskier than debt.