5. Free Cash Flow Valuation

Question 1

Calculate FCFF from net income.

Answer 1

FCFF = NI + NC + (Interests*(1-tax rate)) - FCInv - WCInv + PreferredDiv

NI = Net Income
NC = Non Cash Charges
FCInv = Fixed Capital Investment (CAPEX)
WCInv = Working Capital Investment

Question 2

The most significants non cash charges are usually depreciation and amortization. Give some other examples of noncash charges.

Answer 2

. Provisions for restructuring charges and other noncash losses should be added back to net income. However, if the firm is accruing these costs to cover future cash outflows, then the forecast of future free cash flow should be reduced accordingly. Gains or losses on sale of long-term assets are also removed (they would be accounted for under fixed capital investment).

. Income from restructuring charge reversals and other noncash gains should be subtracted from net income

. For a bond issuer, the amortization of a bond discount should be added back to net income, and the accretion of the bond premium should be subtracted from net income to calculate FCFF

. Deferred taxes, which result from differences in the timing of reporting income and expenses for accounting versus tax purposes, must be carefully analyzed. Over time, differences between book and taxable income should offset each other and have no significant effect on overall cash flows. If, however, the analyst expects deferred tax liabilities to continue to increase (i.e. not reverse), increases in DTL should be added back to net income. Increases in DTA that are not expected to reverse should be subtracted from net income

Question 3

Calculate FCFE from FCFF.

Answer 3

FCFE = FCFF + Net Borrowing - Interest*(1-t)

FCFE = FCFF - Debt - PreferedStocks

Question 4

Calculate FCFE from Net Income.

Answer 4

FCFE = NI + NC - FCInv - WCInv + NetBorrows

NI = Net Income
NC = Non Cash Charges
FCInv = Fixed Capital Investment (CAPEX)
WCInv = Working Capital Investment

Question 5

Calculate FCFF from EBIT.

Answer 5

FCFF = EBIT*(1-t) + Dep - FCInv - WCInv

Dep = depreciation
FCInv = Fixed Capital Investment (CAPEX)
WCInv = Working Capital Investment

Question 6

Calculate FCFF from EBITDA.

Answer 6

FCFF = (EBITDA-Dep)*(1-t) + Dep - FCInv - WCInv

or

FCFF = EBITDA(1-t) + Dept - FCInv - WCInv

Question 7

Calculate FCFF from CFO.

Answer 7

FCFF = CFO + Int*(1-t) - FCInv

Question 8

Explain how dividends, share repurchases, share issues, and changes in leverage may affect future FCFF and FCFE.

Answer 8

This is a deceptively simple LOS. The short answer is that dividends, share repurchases, and shares issues have no effect on FCFF and FCFE.

Changes in leverage have only a minor effect on FCFE an no effect on FCFF. For example, a decrease in leverage through a repayment of debt will decrease FCFE in the current year and increase forecasted FCFE in future years as interest expense is reduced.

Question 9

Which is the appropriate discount rate to a three-stage free-cash flow model?

Answer 9

(1+discount rate a)^p * (1+discount rate b)^q

p: years in first period
q: years in second period

Equity, pg. 178

Question 10

Calculate Forecasted FCFE.

Answer 10

FCFE = NI + Dep - FCInv - WCInv + NetBorrowing

FCFE = NI - [(1-DR)(FCInv - Dep)] - [(1-DR)WCInv]

FCFE = NI+Dep-FCInv-WCInv+(FCInv+WCInv-Dep)*(D/A)

DR = Target debt-to-asset ratio