module 4: free cash flow (fcf) - which cash flows do we...

70391 - Finance

Module 4: Free Cash Flow (FCF)Which cash flows do we discount?

70391 – Finance – Fall 2016Tepper School of BusinessCarnegie Mellon Universityc©2016 Chris Telmer. Some content from slides by Bryan Routledge. Used with permission.

09.26.2016 11:12

Three Main Things

:1: Which cash flows should we discount?I “Free” Cash Flows (FCF)

:2: Make decisions based on how they affect incremental FCF

:: Today: valuation of incremental projects for a firm

:: Next topic: valuation of firm (sum of the projects)

:3: Don’t forget that working capital is capital, just like any otherkind of capital.

FCF 2

What is FCF?

FCF 3

1. Free Cash Flow (of the Business)FCF is NOT NOPAT

Future Free Cash Flow (FCF)

Profitability and Efficiency

Profit margins Operating efficiency Capital (asset) efficiency ROIC

Growth Opportunities New customers New products R&D, innovation

Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty

Market Interest Rates

Efficient Markets Market forces will tend to drive market value toward intrinsic value

Risk

Cost of Capital (%)

Investors required rate-of-return

Intrinsic Value of Operations (Discounted FCF)

Market Value of the Firm

Total Debt

Market Value of Equity

Share Price

Number of Shares

Non-Operating Assets (Cash)

Discounted by

Capital Markets Capital Structure (firm’s choice

of debt and equity)

FCF 4

1. Free Cash Flow (of the Business)FCF is NOT NOPAT

Future Free Cash Flow (FCF)

Profitability and Efficiency

Profit margins Operating efficiency Capital (asset) efficiency ROIC

Growth Opportunities New customers New products R&D, innovation

Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty

Market Interest Rates

Risk

Cost of Capital (%)

Investors required rate-of-return

Intrinsic Value of Operations (Discounted FCF)

Discounted by

Capital Markets Capital Structure (firm’s choice

of debt and equity)

FCF 4

1. Free Cash Flow (of the Business)FCF is NOT NOPAT

Future Free Cash Flow (FCF)

Profitability and Efficiency

Profit margins Operating efficiency Capital (asset) efficiency ROIC

Growth Opportunities New customers New products R&D, innovation

Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty

FCF 4

1. Which Cash Flows?

:: What is the “C” in DCF?

V0 =E(c1

)1 + r

+E(c2

)(1 + r)2

+E(c3

)(1 + r)3

+ . . .

:: NOPAT?

FCF 5

1. What is FCF?

FCF 6

1. Free Cash Flow

:: NOPAT

= Amount of after-tax profit generated by a firm’s businessoperations

:: Free Cash Flow

= Amount of after-tax cash-flow generated by the company’sbusiness operations

:: Ignore interest income (expense), dividends, etc.

:: Include some things that do not appear on the incomestatement (CAPEX, change in working capital)

:: Exclude some things that do appear on the income statement(DDA)

:: “Cash flow available (“free”) to pay to capital providers”

FCF 7

1. Free Cash Flow

:: NOPAT

= Amount of after-tax profit generated by a firm’s businessoperations

:: Free Cash Flow

= Amount of after-tax cash-flow generated by the company’sbusiness operations

:: Ignore interest income (expense), dividends, etc.

:: Include some things that do not appear on the incomestatement (CAPEX, change in working capital)

:: Exclude some things that do appear on the income statement(DDA)

:: “Cash flow available (“free”) to pay to capital providers”

FCF 7

1. Free Cash Flow (of the Business)

FCF 8

1. Free Cash Flow (of the Business)

FCF 9

1. Free Cash Flow: Template[You will see lots of variations in layout. In general, the more it looks like an “income statement” or “cash-flow statement” theeasier it is to communicate]

FCF 10

Incremental FCF

FCF 11

2. Focus on Incremental Free Cash Flow

Future Free Cash Flow (FCF)

Profitability and Efficiency

Profit margins Operating efficiency Capital (asset) efficiency ROIC

Growth Opportunities New customers New products R&D, innovation

Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty

Market Interest Rates

Efficient Markets Market forces will tend to drive market value toward intrinsic value

Risk

Cost of Capital (%)

Investors required rate-of-return

Intrinsic Value of Operations (Discounted FCF)

Market Value of the Firm

Total Debt

Market Value of Equity

Share Price

Number of Shares

Non-Operating Assets (Cash)

Discounted by

Capital Markets Capital Structure (firm’s choice

of debt and equity)

FCF 12

2. Focus on Incremental Free Cash Flow

Future Free Cash Flow (FCF)

Profitability and Efficiency

Profit margins Operating efficiency Capital (asset) efficiency ROIC

Growth Opportunities New customers New products R&D, innovation

Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty

Market Interest Rates

Risk

Cost of Capital (%)

Investors required rate-of-return

Intrinsic Value of Operations (Discounted FCF)

Discounted by

Capital Markets Capital Structure (firm’s choice

of debt and equity)

FCF 12

2. Focus on Incremental Free Cash Flow

Future Free Cash Flow (FCF)

Profitability and Efficiency

Profit margins Operating efficiency Capital (asset) efficiency ROIC

Growth Opportunities New customers New products R&D, innovation

Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty

FCF 12

2. Focus on Incremental Free Cash Flow

Future Free Cash Flow (FCF)

Growth Opportunities New customers New products R&D, innovation

FCF 12

2. Focus on Incremental Free Cash FlowDiscount rate = 10%

Existing firm’s cash flow:

:: $1100 in year 1 and $1210 in year 2 (and zero after that)

Firm considers project that will change cash flow to:

:: $1100 in year 1 and $1331 in year 2 (and zero after that)

How much does project increase PV?

0 1 2 3 . . . t

FCF 13

2. Focus on Incremental Free Cash FlowDiscount rate = 10%

Existing firm’s cash flow:

:: $1100 in year 1 and $1210 in year 2 (and zero after that)

Firm considers project that will change cash flow to:

:: $1100 in year 1 and $1331 in year 2 (and zero after that)

How much does project increase PV?

0 1 2 3 . . . t

FCF 13

2. Not to Forget

:: Focus on incremental cash-flow

= What changes based on your decision

:: Consider all cash-flows (and only once!)

:: Remember “working capital” changes

:: Forget sunk costs

:: Include opportunity costs

:: Remember to account for taxes

FCF 14

Working Capital

FCF 15

3. Working Capital

:: Working Capital that is part of the business includes

:: Inventory

:: Accounts Receivable

:: Accounts Payable

:: Customer Pre-Payments (e.g., gift cards)

:: ...

FCF 16

3. Example

:: Boeing has a jet that sells for $10 million per jet (paid atdelivery) Sales are about 1 per month.

:: How much could you reduce the price of the jet if thecustomer agrees to pay 12 months early?

Other info

:: The jet program is very long term:: Tax Rate is 30%:: Opportunity cost of capital is 8.9%:: Current operating capital (invested capital) for this line of

business is $250

FCF 17

3. Example

:: Boeing has a jet that sells for $10 million per jet (paid atdelivery) Sales are about 1 per month.

:: How much could you reduce the price of the jet if thecustomer agrees to pay 12 months early?

Other info

:: The jet program is very long term:: Tax Rate is 30%:: Opportunity cost of capital is 8.9%:: Current operating capital (invested capital) for this line of

business is $250

FCF 17

3. Example

FCF 18

3. Example: Using FCF Statement

FCF 19

3. Example

:: What happens to ROIC?

NOPAT down, but Invested Capital down too. Net effect depends on pre-projectROIC. If less than 8.4/108, ROIC goes down for all future years. If not, it goes up.Point: NPV > 0 so we should invest. Might make ROIC go down, but this doesn’tmatter.

FCF 20

3. Example

:: What happens to ROIC?

NOPAT down, but Invested Capital down too. Net effect depends on pre-projectROIC. If less than 8.4/108, ROIC goes down for all future years. If not, it goes up.Point: NPV > 0 so we should invest. Might make ROIC go down, but this doesn’tmatter. FCF 20

Monthly Granularity

FCF 21

FCF 22

FCF 23

3. ExampleWe deliver jets in years 1 to 5. Get paid for Year-5 jets in year 4. Deliver jets in Year-5and get no sales revenue. Note that we paytax at delivery date, so tax “savings” happen in Year 5.

:: What if the jet design (i.e., sales) only occur for 5 years?

0 1 2 3 4 5

FCF 24

3. Example

FCF 25

Examples

FCF 26

Example 1

Sales last year were $100,000. Inventory of 10% of sales must be inplace at the start of the year to support sales in the coming year. Ifsales are expected to grow by 12% per year for the next five years,what are the incremental cash flows associated with the growth ininventory? (How big is the “investment” in inventory each year?)

FCF 27

Answer

FCF 28

Wrinkle

Suppose that inventory doesn’t have to be paid for 60 days.

:: AP will be 2/12 of sales

:: Note: doesn’t depend on inventory level (as % of sales).

:: Bathtub metaphor

FCF 29

Wrinkle

Suppose that inventory doesn’t have to be paid for 60 days.

:: AP will be 2/12 of sales

:: Note: doesn’t depend on inventory level (as % of sales).

:: Bathtub metaphor

FCF 29

Answer: 60-Day AP

Notice: growth in sales has an extra kick (positive) to free-cash-flows.Effectively, you are selling to the customer before you have to pay your supplier

FCF 30

Example 2

M Inc. purchases a new asset for $500,000. For odd and peculiarreasons in the tax code it can depreciate the asset over 5 years orover 2 years (straight line). The company can choose. Does itmatter? The tax rate is 35%. Any assumptions you need to make?

:: Remember: Focus on incremental cash flows.

FCF 31

Answer

FCF 32

Note

:: Depreciation matters only via its effect on taxes. Sum of FCFin both is the same. But FCF now is better than FCF later; sodepreciate (for tax) as fast as you can.

:: Assumptions:

:: That you have taxable income. If your effective tax rate is zerosince you are currently losing money, for example, things getcomplicated (e.g., loss carryovers).

:: Tax rate is constant. If future tax rates are expected to behigher, then you might want to save the depreciationdeduction for later years.

FCF 33

Accelerated Depreciation

FCF 34

Example 3

UPMC performs a Tachyon Beam Exam bills at $15 [thousand] pertest. Demand is about 1 per month. The cost is $12 per test (thatis about a 20% margin). Insurance usually pays 12 months afterthe test How much could we reduce the price per exam forpayment 3 months after the test? UPMC is a non-profit, so thetax rate is zero. Cost of capital is 10%. Assume sales at this levelwill continue at this level indefinitely into the future (a simplifyingassumption).

FCF 35

Answer

:: Reduce price from 15 to x . Annual loss in EBIT =12(x − 15), forever, starting now.

:: AR was 180. It will reduce to 3x . Change in AR is 180 - 3x .

:: NPV:

NPV = 180 − 3x + 12(x − 15

)+

12(x − 15

)0.1

:: Solve for x such that NPV =0. This is the largest price dropwe can do.

x = 13.95

FCF 36

Answer

:: Reduce price from 15 to x . Annual loss in EBIT =12(x − 15), forever, starting now.

:: AR was 180. It will reduce to 3x . Change in AR is 180 - 3x .

:: NPV:

NPV = 180 − 3x + 12(x − 15

)+

12(x − 15

)0.1

:: Solve for x such that NPV =0. This is the largest price dropwe can do.

x = 13.95

FCF 36

Answer

:: Reduce price from 15 to x . Annual loss in EBIT =12(x − 15), forever, starting now.

:: AR was 180. It will reduce to 3x . Change in AR is 180 - 3x .

:: NPV:

NPV = 180 − 3x + 12(x − 15

)+

12(x − 15

)0.1

:: Solve for x such that NPV =0. This is the largest price dropwe can do.

x = 13.95

FCF 36

Answer

:: Reduce price from 15 to x . Annual loss in EBIT =12(x − 15), forever, starting now.

:: AR was 180. It will reduce to 3x . Change in AR is 180 - 3x .

:: NPV:

NPV = 180 − 3x + 12(x − 15

)+

12(x − 15

)0.1

:: Solve for x such that NPV =0. This is the largest price dropwe can do.

x = 13.95

FCF 36

Answer

FCF 37

Summary

FCF 38

Valuing the FCF

Which “c” in the numerator? The incremental free cash flow:

:: Start with NOPAT

:: Add back DDA (& any other “non-cash expenses”)

:: Subtract CAPEX

:: Add the reduction in working capital (or subtract the increase)

Discount the free cash flow and compute the PV

:: Figure out the appropriate discount factor

:: Add ’er up!

FCF 39