Hi guys,
I'm valuing a semi-financial institution where people would still use DCF valuation - the issue is that its business incurs bad debt expenses and not sure how to reflect this correctly in FCF. In technical terms seems correct to calc FCF = Net income + D&A + Bad debt expense - NWC - CAPEX , and with NWC calculated by using pre-provisioned receivables.
But the issue is if I increase bad debt the EV as valued by DCF goes UP - Net income goes down by (1-t) of the bad debt expense, but adding back the full bad debt expense afterwards FCF goes up - which seems counterintuitive. ie. if I project bad debt expense as % of revenue, inputting an assumption of 5% would give me a much larger EV than assuming 0%.
Is there a way to somehow justify not adding back the bad debt expense as a non-cash item and still be correct technically?
Interested to know this as well. Seems like when you increase the contra account, your AR goes down hence your -NWC will forever be getting smaller and smaller and value to DCF will be going up
Not a FIGgy, but here are my 5 cents: when you have defaults on your loans, you will take those out of your books against the bad debt (no cash impact). However you will not collect the money either --> negative cash flow impact you're looking for. You cant just build provisions and never use/need them.
Furthermore: you're not adding back the interest, are you working with pre-tax discount rate then? Otherwise double counting for that.
Bad debt expense would also be included in net income, so a higher bad debt expense wouldn’t mean FCF is higher, because it would just be balancing out a lower net income. Changing the bad debt expense assumptions shouldn’t affect FCF.
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