Business/ Firm Valuation

Hand Out

FCFF (Free Cash Flow to Firm) Method of Valuation

Steps
1) Under FCFF valuation model future of an enterprise is divided into -a)forecasting
horizon and b) a period beyond forecasting horizon. Forecasting horizon means near
future like 5 years, 7 years, 10 years or similar short term time horizon in respect of
which cash flow can be estimated with some degree of accuracy. Beyond forecasting
horizon it is normally presumed that either cash flow will be equal to that of the last
year of the forecasting horizon (i.e.5th, 7th or 10th year etc - as the case may be) and the
said cash flow shall remain constant till infinity or the cash flow will grow (till
infinity) at a constant rate over that of the last year of the forecasting horizon.
2) The next step is to estimate the future free cash flow (FCF) of an enterprise for the
forecasting horizon. For the purpose, projected profit and loss account and balance
sheet need to be prepared keeping in mind the economic scenario, industry
environment in which the firm operates and the firm’s own objective. This is a
daunting task. Wrong projection will lead to faulty valuation. FCF in respect of any
year is arrived at as under-
FCF= Net Operating Profit Adjusted for Tax (NOPAT)+ Depreciation –
Investment (net)in Non-current Assets(Capex)–Increase in Working Capital
………………. (1)
Where NOPAT = Earning after Tax (EAT) + Interest ( 1- Marginal tax rate, Tc).

FCF of a particular year (t-th year) is hereinafter denoted as FCFt.

3) The calculation of discount rate involves computation of weighted average cost of

capital (WACC). First we compute the cost of debt and cost of equity. The cost of debt is
the interest cost paid/ payable during a year. As the interest is a tax deductible
expenditure net cost of debt is arrived at as under :

Cost of Debt (Net) = Rd(1- Tc) ………. (2)

Where Rd = Cost of Debt (i.e. Interest Cost)

Tc = Marginal Tax Rate

The cost of equity is computed by using a mathematical model called capital asset
pricing model (CAPM). The term – asset pricing model is a misnomer in the sense that
the model does not evaluate or price any asset per se but provides a simple formula at the
end to determine cost of equity.

The theoretical reasoning behind the model is that when a person invests in the equity
shares of a company he undertakes a risk as he may not get back the invested amount.
The risk is divided into two categories – 1) company specific risk unique to a company
like capability of management, peculiarity of its products, location etc. and 2) market risk
like downturn in the economy. The model assumes that the company specific risk can be
avoided by an investor by taking diverse exposure through investment in shares of
companies belonging to different industries. Hence, the market does not pay him for
taking company specific risk as he can himself avoid it by following judicious investment
strategy. But what he can not avoid is – market risk resulting from macro-economic
phenomenon like downturn in the economy as a whole that impacts all business entities.
Hence, the market pays the investor a return for taking the market risk. Such return is
over and above the return an investor can expect by investing in risk-free Govt. bonds.
The return from the Govt. bond is risk free because the coupon (interest) payment and
repayment of principal are assured as such there is neither any variability of payment
arising from market condition nor any default risk involved. The excess return over the
risk free rate that an investor can expect by investing in equity shares of different
companies (i.e. well-diversified portfolio of equity shares-ideally the market portfolio) is
called ‘market risk premium’.

The total expected return from holding the market portfolio = Risk free Rate (Rf) +

Market Risk Premium (Rm-Rf)

Hence, as per the model there is no point in finding the return required from investing in
the equity share of a particular company given its own risk-profile- rather what one needs
to know is the extent of change of risk profile of a well diversified portfolio by adding a
particular share. In other words, required return of a share should be computed with
reference to variability of return of the share in relation to the variability of return of the
market portfolio as a whole. In Indian context around 7000 plus companies are listed in
the Bombay Stock Exchange. There is no need to consider all 7000 companies. The return
of broad based index like BSE – Sensex or CNX nifty can be taken as a proxy for market
return (Rm). How a return from a stock denoted by Re varies with Rm is measured by

Greek letter ‘beta’ ( β ) and is computed as under :-

β = Covariance between Rmand Re / Variance of Rm …..(3)

Beta being a measure of market risk should be computed by taking daily or weekly return
of one or two years. Computing beta by taking data on return exceeding two years is not
advisable as market risk changes frequently in response to numerous macro-economic
factors.

The required return on equity or in other words cost of equity is computed by using the
following model

Re = Rf+ β (Rm- Rf) ………………………………………(4)

Example 2:IfRf (say return of a mid term Govt. Bond ) bond is 7%. Beta of the stock is
1.2 and market risk premium (Rm- Rf) is 8%. The cost of equity will be 7% + 1.2 X 8% =
16.6%.

In arriving at WACC the market value of the equity share capital is taken as weight of
cost of equity and market value of debt is taken as weight of cost of debt. For all practical
purposes book value of debt is taken as weight for cost of debt as the market value of debt
generally approximates the book value.

We Wd
Re × + Rd (1−T c )
WACC = W e +W d W e +W d ………………………….. (5)

Where We = Weight of the Equity Capital (=Market Value of equity)

And Wd = Weight of the Debt ( = Book Value of Debt)

1) Now the stage is set to compute enterprise value (EV). In computing EV, value till
forecasting horizon taking the same as 5 years is computed as under –
5
t FCF
∑ (1+WACC )t
t=1 ……………………………. (6)
 The value beyond forecasting horizon (=5 years in the given case) called ‘Terminal
Value’ (TV) is computed by assuming a constant growth (=g) of FCFF beyond last year
of the forecasting horizon in the following way

FCF 5 (1+g )
TV5 = WACC−g …………………………(7)

The terminal value computed above represents the value at the end of forecasting horizon
(i.e. end of 5 years here), the same has to be further discounted to get the value today (i.e.
at time to) denoted as TV0

TV 5
TVo = (1+WACC )5 ……………………………(8)

Hence, EV is arrived by adding (6) and (8), that is-

5
FCF
t
TV 5
∑ (1+WACC )t (1+ WACC )5
EV = t=1 + ………………………………..(9)

2) From the equation (9) above, the value of the equity is obtained as under:
Value of the Equity = EV – Book Value of the Debt ………….(10)

3) Beta of a stock computed through equation (3) is levered beta assuming the firm has
already in place target debt ratio. If it is not the case then beta has to be un-levered
and then again re-levered using the target debt ratio.
4) Normally in computing growth (i.e. g in equation 7) the long term projected growth
rate of the industry the enterprise belongs to is considered and in absence thereof the
projected growth rate of the GDP is used.

Free Cash Flow to Equity (FCFE) Valuation:

In the FCFF model we first determine the firm value (enterprise value) by discounting the
total cash flow available to the firm and then deduct value of the debt from firm value to get
the value of the equity. For discounting the cash flow we take WACC of the firm as the
discount factor. In FCFE valuation we directly determine free cash flow to equity and then
discount the FCFE by cost of equity.
FCFE = EAT + Depreciation – Investment (net) in Non-current Assets(Capex)–
Increase in Working Capital + (Debt issued – Debt repaid)

Hence, in FCFE computation our starting point is EAT or PAT – that is, profit available to
equity shareholders net of tax . In case of FCFF it was NOPAT , that operating income
available to both equity holders and debt providers. The treatment of depreciation, investment
in capex and increase of working capital is same under both the models. A further adjustment
for principal of debt raised and debt repayment is required in FCFE model. If generally
interest bearing debt is issued or raised ( that is loan taken) it is considered cash inflow for
equity shareholders for valuation purpose. Similarly when interest bearing debt (loan) is
repaid it is considered as cash outflow for valuation.

FCFE for forecasting horizon and terminal FCFE are computed in the same way as FCFF.
Then FCFE is discounted by cost of equity to determine the value of equity.