Free Cash Flow Valuation

Question 1

What is Free cash flow to the firm (FCFF)?

Answer 1

• Amount of remaining cash after investments and expenses is called free cash flow to the firm (FCFF) because it’s free to pay out to the firm’s investors (see FCFF and FCFE)
• FCFF is used to take care of bondholders because common shareholders are paid after all creditors

Question 2

What is Free cash flow to equity (FCFE)?

Answer 2

• The amount that’s left after the firm has met all its obligations to its other investors
• Cash available to common shareholders after funding capital requirements, working capital needs, and debt financing requirements.

Question 3

What is WACC?

Answer 3

WACC is the required return on the firm’s assets. It’s a weighted average of the required return on common equity and the after-tax required return on debt.

Question 4

How to value a firms equity using FCFE?

Answer 4

Option 01:
* The value of the firm’s equity is the present value of the expected future FCFE discounted at the required return on equity:

equity value = FCFE discounted at the required return on equity

Option 02:
* Value of the firm by simply subtracting out the market value of the debt:

equity value = firm value − market value of debt

Question 5

What are the 4 Advantages of Free-cash flows over DDM?

Answer 5

• Many firms pay no, or low, cash dividends.
• Dividends are paid at the discretion of the board of directors. It may, consequently, be poorly aligned with the firm’s long-run profitability.
• If a company is viewed as an acquisition target, free cash flow is a more appropriate measure because the new owners will have discretion over its distribution (control perspective).
• Free cash flows may be more related to long-run profitability of the firm as compared to dividends.

Question 6

How to value a firms equity using FCFF?

Answer 6

• The value of the firm is the present value of the expected future FCFF discounted at the WACC

Firm value = FCFF discounted at the WACC

Discount FCFF at the WACC to find firm value, and discount FCFE at the required return on equity to estimate equity value.

Question 7

How to calculate FCFF?

Answer 7

FCFF = NI + NCC + [Int × (1 − tax rate)] − FCInv − WCInv
where:
NI = net income
NCC = noncash charges
Int = interest expense
FCInv = fixed capital investment (capital expenditures)
WCInv = working capital investment

Question 7

What is Adjusted present value (APV)?

Answer 7

• When a firm’s capital structure is volatile, the adjusted present value (APV) approach can also be used
• The firm’s unlevered cash flows (i.e., cash flows assuming no impact of leverage) are discounted at the firm’s unlevered cost of equity.
• NPV of debt (the value of the tax shield, less the cost of financial distress) is then added to the unlevered value.

Question 8

What are Noncash changes in the FCFF?

Answer 8

• Represent expenses that reduced reported net income but didn’t actually result in an outflow of cash (eg. Depreciation and deferred taxes, bond discounts)

Question 9

What is and How to calculate Fixed Capital Investment

Answer 9

• Fixed capital investment is a net amount: it is equal to the difference between capital expenditures (investments in long-term fixed assets) and the proceeds from the sale of long-term assets:

FCInv = capital expenditures − proceeds from sales of long-term assets

Question 10

How to calculate FCINv when no assets were sold?

Answer 10

if no long-term assets were sold during the year:

FCInv = ending net PP&E − beginning net PP&E + depreciation

Question 11

What are Interest Expenses in FCFF?9=

Answer 11

• Represents a financing cash flow to bondholders that is available to the firm before it makes any payments to its capital suppliers.
• Don’t add back the entire interest expense, only the after-tax interest cost, because paying interest reduces the tax bill
  Addback as it is included in the FCFF

Question 12

How to calculate FCFE

Answer 12

FCFE = FCFF − [Int × (1 − tax rate)] + net borrowing

• Net borrowing = long- and short-term new debt issues − long- and short-term debt repayments

FCFE = NI + NCC − FCInv − WCInv + net borrowing

FCFE = CFO − FCInv + net borrowing

Question 13

How to calculate FCFF?

Answer 13

• Free cash flow to the firm is the operating cash flow left after the firm makes working capital and fixed capital investment.

Calculating FCFF and FCFE Using the Statement of Cash Flows:

(Almost) FCFF = (NI + NCC − WCInv) − FCInv = CFO − FCInv

(Actual) FCFF = (NI + NCC − WCInv) + Int(1−tax rate) − FCInv = CFO + Int (1−tax rate) − FCInv

FCFF = [EBIT × (1 − tax rate)] + Dep − FCInv − WCInv

FCFF = [EBITDA × (1 − tax rate)] + (Dep × tax rate) − FCInv − WCInv

FCFF = CFO + [Int × (1 − tax rate)] − FCInv

Question 13

What Adjustments Calculating FCFE and FCFF when there is equity raised through preferred shares?

Answer 13

The use of preferred stock requires the analyst to revise the FCFF and FCFE formulas to reflect the payment of preferred dividends and any issuance or repurchase of such shares.

• Any preferred dividends should be added back to the FCFF, just as after-tax interest charges are in the net income approach to generating FCFF.

○ Assumes that net income is net income to common shareholders after preferred dividends have been subtracted out.
○ The WACC should also be revised to reflect the percent of total capital raised by preferred stock and the cost of that capital source.
○ The only adjustment to FCFE would be to modify net borrowing to reflect new debt borrowing and net issuances by the amount of the preferred stock.