Finance - Free Cash Flow Valuation - Lecture - S G Raja Sekharan, Lecture notes of Financial Management

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Free Cash Flow Valuation

Intro to Free Cash Flows

 Dividends are the cash flows actually paid to

stockholders

 Free cash flows are the cash flows available for

distribution.

 Applied to dividends, the DCF model is the

discounted dividend approach or dividend discount

model (DDM). This chapter extends DCF analysis

to value a firm and the firm’s equity securities by

valuing its free cash flow to the firm (FCFF) and

free cash flow to equity (FCFE).

Intro to Free Cash Flows

 Common equity can be valued by either

 directly using FCFE or

 indirectly by first computing the value of the firm

using a FCFF model and subtracting the value of

non-common stock capital (usually debt and

preferred stock) to arrive at the value of equity.

Defining Free Cash Flow

 Free cash flow to the firm (FCFF) is the cash flow

available to the firm’s suppliers of capital after all operating expenses have been paid and necessary investments in working capital and fixed capital have been made.

 FCFF is the cash flow from operations minus capital expenditures. To calculate FCFF, differing equations may be used depending on what accounting information is available. The firm’s suppliers of capital include common stockholders, bondholders, and, sometimes, preferred stockholders.

1

FCFF

Firm Value (1 WACC)

t t t







Valuing FCFF

 The FCFF valuation approach estimates the value

of the firm as the present value of future FCFF

discounted at the weighted average cost of capital

(WACC)

 Discounting FCFF at the WACC gives the total value of

all of the firm’s capital. The value of equity is the value

of the firm minus the market value of the firm’s debt

Valuing FCFF

 Equity Value = Firm Value – Market Value of

Debt

 Dividing the total value of equity by the

number of outstanding shares gives the value

per share.

Calculating a WACC

 If the suppliers of capital are creditors and stockholders, the required rates of return for debt and equity are the after-tax required rates of return for the firm under current market conditions. The weights that are used are the proportions of the total market value of the firm that are from each source, debt and equity.

 MV(debt) and MV(equity) are the current market values of debt and equity, not their book or accounting values. The weights will sum to 1.0.

d re MV debt MV equity

MV equity r Tax rate MV debt MV equity

MV debt WACC ( ) ( )

( ) ( 1 ) ( ) ( )

( )



  



Valuing FCFE

 The value of equity can also be found by discounting

FCFE at the required rate of return on equity (r):

 Since FCFE is the cash flow remaining for equity

holders after all other claims have been satisfied,

discounting FCFE by r (the required rate of return on

equity) gives the value of the firm’s equity.

 Dividing the total value of equity by the number of

outstanding shares gives the value per share.

1

FCFE

Equity Value (1 )

t t t r







Single-stage, constant-growth FCFE

valuation model

 FCFE in any period will be equal to FCFE in the

preceding period times (1 + g):

 FCFEt = FCFEt– 1 (1 + g).

 The value of equity if FCFE is growing at a

constant rate is

 The discount rate is r, the required return on

equity. The growth rate of FCFF and the growth

rate of FCFE are frequently not equivalent.

FCFE 1 FCFE (1 0 ) Equity Value

g

r g r g

    

Computing FCFF from Net Income

 Free cash flow to the firm (FCFF) is the cash flow

available to the firm’s suppliers of capital after all operating expenses (including taxes) have been paid and operating investments have been made. The firm’s suppliers of capital include creditors and bondholders and common stockholders (and occasionally preferred stockholders that we will ignore until later). Free cash flow to the firm is:

FCFF = Net income available to common shareholders Plus: Net Non-Cash Charges

Plus: Interest Expense times (1 – Tax rate) Less: Investment in Fixed Capital Less: Investment in Working Capital

Computing FCFF from CFO

 To estimate FCFF by starting with cash flow from

operations (CFO), we must recognize the treatment of

interest paid. If, as the case with U.S. GAAP, the

after-tax interest was taken out of net income and out

of CFO, after-tax interest must be added back in order

to get FCFF. So free cash flow to the firm, estimated

from CFO, is

FCFF = Cash Flow from Operations Plus: Interest Expense times (1 – Tax rate) Less: Investment in Fixed Capital

Computing FCFF from CFO

 Or you can write the equation as:

FCFF = CFO + Int(1 – Tax rate) – Inv(FC)

Non-cash charges

 Deferred taxes result from a difference in

timing of reporting income and expenses on

the company’s tax return. The income tax

expense deducted in arriving at net income

for financial reporting purposes is not the

same as the amount of cash taxes paid.

Over time these differences between book

and taxable income should offset each other

and have no impact on aggregate cash flows.

In this case, no adjustment would be

necessary for deferred taxes.

Non-cash charges

 If the analyst’s purpose is forecasting and he seeks to

identify the persistent components of FCFF, then it is

not appropriate to add back deferred tax changes that

are expected to reverse in the near future. In some

circumstances, however, a company may be able to

persistently defer taxes until a much later date. If a

company is growing and has the ability to indefinitely

defer tax liability, an analyst adjustment (add-back) is

warranted. An acquirer must be aware, however, that

these taxes may be payable at some time in the future.