Week 1: Cash Flows Flashcards
Why do we use FCF in the firm value calculation?
FCFF determines how much can potentially be paid out to the claim holders.
Things to consider in the computation of FCFF?
*Since we forecast FCF into the future these forecasts involve a lots of uncertainty
*More detail does not necessarily mean more precise forecasts, but it increases complexity.
*Only use reliable information
Types of expenses
− Operating expenses: Expenses that generate benefits for the firm only in the current period (e.g.,
labor, material).
− Capital expenses: Expenses that generate benefits over multiple periods (e.g., land, building,
equipment).
− Financial expenses: Expenses that are associated with non-equity capital of the firm (e.g., interest
expenses).
Only operating expenses used to calculate EBIT.
Forecasts: sources
− Business plan
− Company guidance
− Analysts
− Estimize (“the crowd”)
− Historical data
− Industry data
Reasons for differences between the effective tax rate and the marginal tax rate.
1) First layers of income taxed at lower rates than subsequent layers
2) Different accounting standards for tax purposes and reporting purposes
3) Tax subsidies
4) Taxes deferred to future periods
5) Different tax regimes in different countries
6) Operating losses carried forward
Which tax rate to use in financial valuation: effective or marginal?
− In financial valuation, we usually use the marginal tax rate rather than the effective tax rate because
some of the reasons for lower effective tax rates cannot be sustained in perpetuity (e.g., tax
subsidies are rarely perpetual; taxes deferred to future periods have to be paid at some point).
− However, we can include a transition period, in which the tax rate converges from the effective tax
rate to the marginal tax rate.
Tax rate for multinational firms
1) Marginal tax rate at the firm‘s headquarters
2) Weighted average of the different marginal tax rates
3) Different marginal tax rates for different income streams from different countries
LCF effect on CFs
–>For firms with large net operating losses carried forward, there is the potential for significant tax savings in the first few years that they generate positive earnings.
− In the early years, these firms will have a zero tax rate as losses carried forward offset profits.
− When operating losses carried forward decrease, the tax rate will climb toward the marginal tax
rate.
Net Capex
− Capital expenditures are investments in LONG-LIVED assets.
− Net capital expenditures is the difference between capital expenditures and depreciation and amortization.
Function: to determine how fast the firm is growing or expected to grow.
− High growth firms: High net capital expenditures
− Low growth firms: Low net capital expenditures
It typically makes sense to estimate net capital expenditures as a percentage of revenue or as a
percentage operating profit.
Change in NWC
− Increases in (non-cash) working capital are investments in SHORT-TERM assets.
− For valuation purposes, net working capital is usually defined as accounts receivable plus inventory minus accounts payable.
Function: determine how fast the firm is growing or expected to grow.
− High growth firms: High change in net working capital
− Low growth firms: Low change in net working capital
It typically makes sense to estimate net working capital as a percentage of revenue.
Net working capital can decrease if it is managed more efficiently. This releases cash and increases the cash flows of the firm. However, this cannot go forever. At some point, there will be no more inefficiency left.
Why do we use FCFE to determine firm value?
The free cash flow to equity captures how much cash flow can potentially be paid out to shareholders.
Dividends capture how much cash flow is actually paid out to shareholders.
Free cash flow to equity = Dividends?
->No, only if you pay out ALL FCFE as dividends.
Why do firms pay out less than the free cash flow to equity?
1) Desire for stability / signaling
2) Future investment needs
3) Tax factors
4) Managerial self-interest
−>Thus, dividends are usually a poor proxy for the free cash flow to equity.
