finvest free cash flow valuation slides

7/31/2019 FINVEST Free Cash Flow Valuation Slides

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Investment Analysis and Portfolio Management (FINVEST)

K31 & K32 2nd Term AY 2009-2010Mr. Clive Manuel O. Wee Sit, CTP

Analysts like to use free cash flow as return

(either FCFF or FCFE) whenever one or more ofthe following conditions is present: The company is not dividend paying;

The company is dividend paying but dividends differsignificantly from the companys capacity to paydividends;

Free cash flows align with profitability within areasonable forecast period with which the analyst iscomfortable; or

The investor takes a control perspective.

Free Cash Flow to the Firm (FCFF) is the

cash flow available to the companyssuppliers of capital after all operatingexpenses (including taxes) have been paid

and necessary investments in working capital(e.g., inventory) and fixed capital (e.g.,

equipment) have been made.

Free Cash Flow to Equity (FCFE) is the cash

flow available to the companys commonequity holders after all operating expenses,interest, and principal payments have been

paid and necessary investments in workingand fixed capital have been made.

The advantage of FCFF and FCFE is that theycan be used in a DCF framework to value the

firm or to value equity. Other earnings measures such as net income,

EBIT, EBITDA, and CFO do not have thisproperty because they either double-count oromit cash flows in some way.

The FCFF valuation approach estimates thevalue of the firm as the present value of

future FCFF discounted at the weightedaverage cost of capital (WACC):

( )

= +

=

1 1tt

t

WACC

FCFFFirmValue


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The value of equity is the value of the firmminus the value of the firms debt:

Equity value = Firm value Market value of debt

Dividing the total value of equity by the numberof outstanding shares gives the value per share.

The WACC formula is

( )

( ) ( )( )

( )

( ) ( )r

EquityMVDebtMV

EquityMVTaxrater

EquityMVDebtMV

DebtMVWACC d

+

+

+

= 1

The value of the firm if FCFF is growing at a

constant rate is

( )

gWACC

gFCFF

gWACC

FCFFFirmValue

+=

=1

01

Problem 1:

Cagiati Enterprises has FCFF of CHF 700 million and FCFE ofCHF 620 million. Cagiatis before-tax cost of debt is 5.7percent and its required rate of return for equity is 11.8percent. The company expects a target capital structureconsisting of 20 percent debt financing and 80 percentequity financing. The tax rate is 33.33 per cent, and FCFF isexpected to grow forever at 5.0 percent. Cagiati has debtoutstanding with a market value of CHF 2.2 billion and has200 million outstanding shares.

What is Cagiatis weighted average cost of capital? What isthe total value of Cagiatis equity using the FCFF valuationapproach? What is the value per share using this approach?

Solution to Question 1 of Problem 1:



( )( ) ( ) %2.10%8.1180.03333.01%7.520.0 =+=WACC

( ) ( )

millionCHF

gWACCgFCFF

gWACCFCFFFirmValue

6.134,14

052.0735

05.0102.005.1700101

=

=

=

+=

=

millionCHFmillionCHFmillionCHFeEquityValu 6.934,11200,26.134,14 ==

pershareCHFresmillionshamillionCHFV 67.59200/6.934,110 ==

With the FCFE valuation approach, the valueof equity can be found by discounting FCFE atthe required rate of return on equity (r):

Dividing the total value of equity by thenumber of outstanding shares gives the valueper share.

( )

= +

=

1 1tt

t

r

FCFEeEquityValu


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The value of equity if FCFE is growing at aconstant rate is

( )

gr

gFCFE

gr

FCFEeEquityValu

+=

=1

01

FCFF = Net income available to common shareholders

Plus: Net noncash chargesPlus: Interest expense x (1 Tax rate)Less: Investment in fixed capitalLess: Investment in working capital

FCFF = NI + NCC + Int (1 Tax rate) FCInv WCInv

FCFF = Cash Flow from OperationsPlus: Interest expense x (1 Tax rate)Less: Investment in fixed capital

FCFF = CFO + Int (1 Tax rate) FCInv

Noncash Item Adjustment to NI to Arrive at FCFF

Depreciation Added back

Amortization and impairment of

intangibles

Added back

Re st ru ct ur in g ch arge s ( ex pe ns e) Ad de d ba ck

Restructuring charges (income resulting

from reversal)

Subtracted

Losses Added back

Gains Subtracted

Amortization of long-term bond

discounts

Added back

Amortization of long-term bond

premiums

Subtracted

Deferred taxes Added back but calls for special attention

FCFF = Net income available to common shareholdersPlus: Net noncash chargesLess: Investment in fixed capital

Less: Investment in working capitalPlus: Net Borrowing

FCFF = NI + NCC FCInv WCInv + Net Borrowing

FCFE = Free Cash Flow to the FirmLess: Interest expense x (1 Tax rate)Plus: Net Borrowing

FCFE = FCFF Int(1 Tax rate) + Net Borrowing


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To show the relationship between EBIT and FCFF, we start with

the basic equation of FCFF starting from NI and assume that theonly NCC is depreciation (Dep):

FCFF = NI + Dep + Int (1 Tax rate) FCInv WCInv

Net income (NI) can be expressed as

NI = (EBIT Int)(1 Tax rate) = EBIT (1 Tax rate) Int (1 Tax rate)

Substituting this equation for NI, we have

FCFF = EBIT (1 Tax rate) + Dep FCInv WCInv

It is also easy to show the relation between FCFF from

EBITDA. Net income is expressed as

NI = (EBITDA Dep Int)(1 Tax rate) = EBITDA (1 Tax rate) Dep (1 Tax rate) Int (1 Tax rate)

Substituting this equation for NI

FCFF = EBITDA (1 Tax rate) + Dep (Tax rate) FCInv WCInv

To calculate FCFE from EBIT or EBITDA, derive FCFF usingabove equations then deduct Int (1 tax rate) and add netborrowing.

Finding CFO, FCFF, and FCFE may require

careful interpretation of corporate financialstatements.

In some cases, the needed information may

not be transparent.

FCFF or FCFE valuation expressions can be

easily adapted to accommodate complicatedcapital structures, such as those that includepreferred stock.

A general expression for the two-stage FCFFvaluation model is

( ) ( ) ( )=

+

+

+

+

=

n

tn

n

t

t

WACCgWACC

FCFF

WACC

FCFFFirmValue

1

1

1

1

1

A general expression for the two-stage FCFEvaluation model is

( ) ( )=

+

+

+

+

=

n

tn

n

t

t

rgr

FCFE

r

FCFEeEquityValu

1

1

1

1

1


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There are two basic types of two-stagemodels:

Fixed growth rates in stage 1 and stage 2

Declining growth rate in stage 1 and constantgrowth in stage 2

To forecast FCFF and FCFE, analysts build avariety of models of varying complexity.

A common approach is to forecast sales, withprofitability, investments, and financing

derived from changes in sales. A simpler way of forecasting would be to

apply a growth rate to FCFF and FCFE.

Three-stage models are a straightforward

extension of the two-stage models. There are two common versions of a three-

stage model:

Assume a constant growth rate for each of thethree stages

Constant growth rates in stages 1 and 3 and adeclining growth rate in stage two

Nonoperating assets, such as excess cash nd

marketable securities, noncurrent investmentsecurities, and nonperforming assets, areusually segregated from the companys

operating assets. They are valued separately and then added to

the value of the companys operating assetsto find total firm value.

Value of Firm = Value of Operating Assets+ Value of Nonoperating Assets

Equity Asset Valuation by Stowe, Robinson,Pinto, & McLeavey, 2007

Equity, CFA Program Level 2 Curriculum 2010

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