Reading 36 - Free Cash Flow Valuation

Question 1

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

Answer 1

the cash available to all of the firm’s investors, including stockholders and bondholders, after the firm buys and sells products, provides services, pays its operating expenses, and makes short and long term investments

Question 2

What is Free Cash flow to Equity (FCFE)?

Answer 2

the cash available to common shareholders after funding capital requrements, working capital needs, and debt financing requirements

Question 3

How do you calculate the value of a firm?

Answer 3

firm value = FCFF discounted at the WACC

Question 4

What are the two ways do value a firm’s equity?

Answer 4

1. equity value = FCFE discounted at the required return on equity
2. equity value = firm value - market value of debt

Question 5

What are the reasons analysts prefer to use free cash flow rather than dividend-based valuations?

Answer 5

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

Question 6

How do you calculate FCFF when you are given Net Income?

Answer 6

FCFF = NI + NCC+[Interest Expense *(1-tax rate)] - FCInv - WCInv

Question 7

What are the most common noncash charges (NCC) that get added back to calculate FCFF?

Answer 7

1. Amortization of intangibles that should be added back
2. Provisions for restructuring
3. Income from restructuring charge reversals
4. Amortization of a bond discount. Also, the accretion of the bond premium should be subtracted
5. Deferred taxes

Question 8

How do you calculate Fixed Capital Investment (FCInv) for use in calculating FCFF?

Answer 8

If no long term assets were sold during the yr

FCInv = capital expenditures = ending gross PP&E - beginning gross PP&E

or

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

Question 9

How do you calculate FCFF when using a Statement of Cash flows

Answer 9

FCFF = (NI+NCC-WCinv)+ Int(1-tax rate)-FCInv

= CFO + Int(1-tax rate) - FCInv

Question 10

How do you calculate FCFF when given EBIT….

Answer 10

FCFF = [EBIT*(1-tax rate)] + Dep - FCInv - WCInv

Question 11

How do you calculate FCFF when given EBITDA?

Answer 11

FCFF = [EBITDA * (1-tax rate)] +(Dep * tax rate) - FCInv - WCInv

Question 12

How do you calculate FCFE when given FCFF?

Answer 12

FCFE = FCFF - [Int*(1-tax rate)] + net borrowing

Net borrowing = long & short term new debt issues -

long & short term debt payments

Question 13

How do you calculate FCFE when given Net Income (NI)?

Answer 13

FCFE = Net Income + NCC - FCInv - WCInv + Net Borrowing

Net borrowing = Long & Short term new debt issues -

Long & Short term debt payments

Question 14

How do you calculate FCFE when given CFO (Cash Flow from Operations) ?

Answer 14

Question 15

How do you calculate WCInv (Working Capital Investments) that is used in FCFE and FCFF formulas?

Answer 15

WCInv is the change in the working capital accounts

WCInv = (Accts Rec_y1+Inv_y1-AcctsPay_y1)-(AcctsRec_y0+Inv_y0-AcctsPay_y0)

Question 16

How do you calculate Net Borrowing that is used in FCFE and FCFF formulas?

Answer 16

Net borrowing is the difference between the long term and short term debt accounts

net borrowing = (LT Debt_yr1+ST Debt_Yr1)-(LT Debt_Yr0+ST Debt_Yr0)

Question 17

Compare the FCFE model and dividend discount model….

Answer 17

The FCF to equity approach takes a control perspective that assumes that recognition of value should be immediate. Dividend discount models take a minority perpspective, under which value may not be realized until the dividend policy accurately reflects the firm’s long-run profitability

Question 18

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

Answer 18

• Dividends, shares repurchases and share issues have no effect on FCFF and FCFE
• Change in leverage only has a minor effect on FCFE and no effect on FCFF

Question 19

Is Net Income a good proxy for FCFE?

Answer 19

No!, b/c you have to add back non-cash charges like depreciation & things that don’t appear on the I/S like working capital and net borrowing

Question 20

Is EBITDA a good proxy for FCFF?

Answer 20

No!, b/c it doesn’t reflect the cash taxes paid by the firm, and it ignores the cash flow effects of the investments in working capital and fixed capital

Question 21

A Single Stage FCFF model should be used on companies that have what characterstics?

Answer 21

Stable firms in mature industries

Question 22

What are the two assumptions that Single Stage FCFF Model makes?

Answer 22

1. FCFF grows at a constant rate (g) forever
2. growth rate is less than the weighted average cost of capital (WACC)

Question 23

What is the formula for the Single Stage FCFF model?

Answer 23

Question 24

What is the formula for the Single Stage FCFE model?

Answer 24

Question 25

Explain the use of sensitivity analysis in FCFE and FCFF valuations.

Answer 25

Sensitivity Analysis shows how sensitive an analyst’s valuation results are to changes in each of a model’s input.

Question 26

How do you calculate CFO ( Cash Flow from Operations) ?

Answer 26

= Net Income + Non-Cash Charges - Working Capital Investments

Question 27

Why do we add back interest expense to calculcate either FCFF or FCFE?

Answer 27

b/c After-tax interest expense is classified as a financing outflow instead of an operating outflow