Reading 24: Free Cash Flow Valuation

Question 1

Free cash flow to firm (FCFF)

Answer 1

• Money free to pay out to the firm’s investors (stockholders and bondholders)
• making interest payments to bondholders has one advantage for shareholders: it reduces the tax bill

Question 2

Free cash flow to equity (FCFE)

Answer 2

-the amount left after the firm has met all its obligations to its other investors

Question 3

General Flow of cash flow

Answer 3

Cash revenues -> pay: working capital investment, fixed capital investments, cash operating expenses (including taxes, but not interest expense) = FCFF

FCFF - interest payments to bondholders + net borrowing from bondholders = FCFE

Question 4

Firm Value or equity value

Answer 4

FCFF discounted by WACC

FCFE discounted by the required return on equity

Question 5

Ownership perspective with free cash flow

Answer 5

-perspective is that of an acquirer who can change the firm’s dividend policy, which is a control perspective, or for minority shareholders of a company that is a takeover target

Question 6

Calculating FCFF from net income

Answer 6

FCFF = NI + NCC + [Int x (1 - t)] - FCInv - WCInv

Question 7

Noncash Charges

Answer 7

• reported in net income, but did not actually result in the outflow of cash
  
  • Ex: depreciation, amortization, provisions for restructuring charges, deferred taxes

Question 8

Fixed Capital Investment

Answer 8

-do not appear in net income, but do result in cash leaving the firm.

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

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

If long-term assets were sold during the year:

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

Question 9

Working Capital Investment

Answer 9

-Equal to the change in working capital, excluding cash, cash equivalents, notes payable and the current portion of long-term debt.

***There is a plus (+) sign in front of a reduction in working capital; we add it back because it represents a cash inflow.

Question 10

Variation of Formulae

Answer 10

Net Income
\+NCC
-WCInv
=CFO
\+ Int * (1-t) 
-FCInv
=Actual FCFF
-Int * (1-t) 
=FCFE
-dividends
\+/- repurchases 
=Net change in cash

Question 11

FCFF from CFO

Answer 11

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

Question 12

FCFE from FCFF

Answer 12

FCFE = FCFF - Int * (1-t) + net borrowing

Question 13

FCFF from EBIT

Answer 13

FCFF = [EBIT x (1 - t)] + Dep - FCInv - WCInv

Question 14

FCFF from EBITDA

Answer 14

FCFF = [EBITDA x (1 - t)] + (Dep x t) - FCInv - WCInv

Question 15

FCFE from net income

Answer 15

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

Question 16

FCFE from CFO

Answer 16

FCFE = CFO - FCInv + net borrowing

Question 17

FCFE with target debt ratio

Answer 17

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

DR = target debt-to-asset ratio

Question 18

Dividend, share repurchases and share issues effects on FCFF and FCFE

Answer 18

-Dividend, share repurchases and share issues have no effect on FCFF and FCFE; changes in leverage have only a minor effect on FCFE and no effect on FCFF

Question 19

Single stage models

Answer 19

FCFF1 / (WACC-g) = value of the firm
WACC = (We x Re) + [Wd x Rd x (1-t)]

FCFE1 / (r-g) = value of equity

**WACC is calculated using target capital weights