C4.2. If cash is king, his subjects are not well served.

Look at the cash flows for General

Electric and Starbucks in Exhibit 4.2. Free cash flow does not incorporate accrual aspects of

value added. Free cash flow is reduced by investments, yet investment (typically) adds value.

Free cash flow is a liquidation concept, not a value-added concept.

E4.1. A Discounted Cash Flow Valuation

2012 2013 2014 2015

Cash flow from operations $1,450 1,576 1,718

Cash investment $1,020 1,124 1,200
Free cash flow $ 430 452 518

Discount rate (1.10)t 1.10 1.21 1.331

PV of cash flows 391 374 389
Total PV to 2015 $1,154
Continuing value* 8,979
PV of CV 6,746
a. Enterprise value $7,900 million
Net debt 759
b. Value of equity $7,141 million

518  1.04

1.10  1.04
* Continuing value = 8,989

E4.2. A Simple DCF Valuation

430
F
V2012 
1.10  1.05

= $8,600 million

E4.3. Valuation with Negative Free Cash Flows

Calculate free cash flow from the forecasts of cash flow from operations and cash investments.
Your will see that free cash flow is negative in all years except 2013:
 2013 2014 2015 2016

Cash flow from operations 730 932 1,234 1,592

Cash investments 673 1,023 1,352 1,745
Free cash flow 57 ( 91) ( 118) ( 153)

If you calculate the present value of these free cash flows (with any discount rate), you’ll get a
negative price. Prices can’t be negative (with limited liability). The continuing value must be
greater than 100% of the price, but we have no way to calculate it. The free cash flows are
increasingly negative because, while cash flow from operations are positive and increasing, the
firm is investing more.

E4.4. Calculate Free Cash Flow from a Cash Flow Statement

Cash flow from operations reported $5,270

Interest payments $1,342
Interest receipts 876
Net interest payments 466
Tax at 35% 163 303
Cash flow from operations 5,573

Cash investments reported $6,417

Purchase of short-term investments (4,761)
Sale of short-term investments 547 2,203
Free Cash Flow 3,370

E4.7. Calculating Cash Flow from Operations and Cash Investment for Coca-Cola

Cash flow from operations:

Reported cash flow from operations $7,150

Interest paid $405
Interest received 236
Net interest paid 169
Tax deduction (at 36%) 61 108
Cash from operations $7,258 million

Cash investment:

Reported cash investment $6,719

Sale of investments $ 448
Purchase of investments (99) 349
 Cash investment in operations $7,068

Coke’s free cash flow was $7,258 – 7,068 = $190.

E4.8. Converting Forecasts of Free Cash Flow to a Valuation: Coco-Cola Company

This exercise demonstrates declining free cash flow on rising investment.
________________________________________________________________________
2004 2005 2006 2007

Cash flow from operations 5,929 6,421 5,969 7,258

Cash investments 618 1,496 2,258 7,068
Free cash flow 5,311 4,925 3,711 190

Though positive, the free cash flows are declining over the four years. If cash flows from
operations and cash investments were declining at about the same rate, we might conclude that
the firm indeed was in a state of decline: declining cash flows from the business lead to declining
investments. However, cash flows from operations are increasing and cash investment is
increasing at a faster rate: Coke is investing heavily. While free cash flow is declining over these
years, one would thus expect it to increase in future years as cash from the rising investment here
comes in. These cash flow are not a good indication of future free cash flows (and nor is the
$190 million of free cash flow in 2007 a good base to calculate a continuing value.)
If you were valuing Coke at the beginning of 2004 based on these subsequent cash flows, you
would have a big problem: you would have to forecast the cash flows after 2007 that the new
investment from 2005-2007 would produce. That is a difficult task, and it would extend the
forecast horizon to a point where outcomes are more uncertain.

The exercise is a good example of why free cash flow does not work, in principle: Investment
(which is made to generate cash flows actually decreases free cash flow, so rising investment
relative to cash flow from operations (lower free cash flow) typically means higher free cash
flow later.
E4.10. A Discounted Cash Flow Valuation: General Mills, Inc.

a. The exercise involves calculating free cash flows, discounting them to present value, then
adding the present value of a continuing value. For part (a) of the question, the continuing value
has no growth:

2005 2006 2007 2008 2009

Cash flow from operations 2,014 2,057 2,095 2,107
Cash investment in operations 300 380 442 470
Free cash flow (FCF) 1,714 1,677 1,653 1,637
Discount rate 1.09 1.1881 1.2950 1.4116
Present value of FCF 1,572 1,411 1,276 1,160
Total of PV to 2009 5,419
Continuing value (CV) 18,189
PV of CV 12,885
Enterprise value 18,304
Net debt 6,192
Equity value 12,112

Value per share on 369 million shares = $32.82

1,637
 18,189
0.09
CV (no growth) =
18,189
 12,885
1.4116
PV of CV =

b. With growth of 3% after 2009, the continuing value is:

1,637  1.03
CV   $28,102
1.09  1.03

The present value of the continuing value is $28,102/1.4116 = $19,908.

Do the valuation is as follows:

Total of PV to 2009 5,419

Continuing value (CV) 28,102
PV of CV 19,908
Enterprise value 25,327
Net debt 6,192
Equity value 19,135

Value per share on 369 million shares = $51.86.

E4.12. Cash Flows for Wal-Mart Stores

a. Wal-Mart is an expanding company with opportunities to invest in new stores throughout

the world. While it generates considerable cash flow from operations, cash investments

routinely exceed cash from operations. So free cash flow is negative. This is a firm like

General Electric in Exhibit 4.2. DCF analysis will not work for this firm.

b. The difference between earnings and cash from operations is due net interest (after-tax)

and accruals.

The difference between earnings and free cash flows is due to net interest (after

tax), accruals and investments in operations.

c. DCF will not work. Negative free cash flows yield negative values.