FREE CASH FLOW TO EQUITY 1.

Desire for Stability Firms are generally reluctant to

change dividends; and dividends are considered 'sticky'
DISCOUNT MODELS because the variability in dividends is significantly
lower than the variability in earnings or cashflows

2. Future Investment Needs: A firm might hold back on

paying its entire FCFE as dividends, if it expects
substantial increases in capital expenditure needs in the
future. Since issuing securities is expensive (from a
flotation cost standpoint), it may choose to keep the
excess cash to finance these future needs.

 This is the cash flow available to be paid out as

3. Tax Factors: If dividends are taxed at a higher tax rate
than capital gains, a firm may choose to retain the
dividends or stock buybacks. excess cash and pay out much less in dividends than it
has available. This is likely to be accentuated if the
stockholders in the firm are in high tax brackets, as is
the case with many family-controlled firms.

4. Signaling Prerogatives: Firms often use dividends as

signals of future prospects, with increases in dividends
being viewed as positive signals and decreases as
negative signal

5. Managerial Self-interest: The managers of a firm may

gain by retaining cash rather than paying it out as a
dividend. The desire for empire building may make
increasing the size of the firm an objective on its own.

Comparing Dividends to Free Cash Flows

to Equity FCFE Valuation Models
The conventional measure of dividend policy –– the dividend In fact, one way to describe a free cash flow to equity model is that
payout ratio –– gives us the value of dividends as a proportion of it represents a model where we discount potential dividends rather
earnings. In contrast, our approach measures the total cash returned than actual dividends
to stockholders as a proportion of the free cash flow to equity.
Underlying Principle

When we replace the dividends with FCFE to value equity, we are

doing more than substituting one cash flow for another. We are
implicitly assuming that the FCFE will be paid out to stockholders.
There are two consequences.
1. There will be no future cash build-up in the firm, since
the cash that is available after debt payments and
reinvestment needs is paid out to stockholders each
period.
 The ratio of cash to FCFE to the stockholders shows 2. The expected growth in FCFE will include growth in
income from operating assets and not growth in income
how much of the cash available to be paid out to
from increases in marketable securities. This follows
stockholders is actually returned to them in the form of directly from the last point
dividends and stock buybacks

Why Firms may pay out less than is

available
Many firms pay out less to stockholders, in the form of dividends
and stock buybacks, than they have available in free cash flows to
equity. The reasons vary from firm to firm and we list some below.
FIRM VALUATION: COST OF
CAPITAL AND APV
APPROACHES
This chapter develops another approach to valuation where the
entire firm is valued, by either discounting the cumulated
cashflows to all claim holders in the firm by the weighted average
cost of capital (the cost of capital approach) or by adding the
marginal impact of debt on value to the unlevered firm value
(adjusted present value approach).
Growth in FCFE versus Growth in FCFF
Will equity cashflows and firm cashflows grow at the same rate?
Consider the starting point for the two cash flows. Equity cash
flows are based upon net income or earnings per share – measures
of equity income. Firm cash flows are based upon operating
income – i.e. income prior to debt payments. As a general rule, you
would expect growth in operating income to be lower than growth
in net income, because financial leverage can augment the latter.

The Free Cashflow to the Firm

The free cashflow to the firm is the sum of the cashflows to all
claim holders in the firm, including stockholders, bondholders and
preferred stockholders. There are two ways of measuring the free
cashflow to the firm (FCFF).

Note: that we are reversing the process that we used to get to free
cash flow to equity, where we subtracted out payments to lenders
and preferred stockholders to estimate the cash flow left for
stockholders. A simpler way of getting to free cash flow to the firm
is to estimate the cash flows prior to any of these claims. Thus, we
could begin with the earnings before interest and taxes, net out
taxes and reinvestment needs and arrive at an estimate of the free
cash flow to the firm.

FCFF and other cashflow measures

 Cash Flow
 FCFF
 FCFE
 EBITDA
 EBIT(1-T)