Firm Free Cash Flows

Developed and Presented by

Dr Angelo Aspris
Discipline of Finance

The University of Sydney Page 1

 Learning Outcomes
– What are Free Cash Flows?
– What are the different forms?
– How are FCFE and FCFF computed?.

– The impact of leverage on FCF.

– What is the terminal value period?

– What is a reasonable forecast horizon period?
– How are cash flows expected to change in the terminal period?

The University of Sydney Page 2

 Recap - Discounted Cash Flow (DCF) Valuation

– Intrinsic value of a firm = PV of expected cash flows.

CF1 CF2 CF3 CFn

Value    ... 
1  r1 1  r 2 1  r 3 1  rn

– DCF relies on positive cash flows over the life of the asset and value is
determined by the magnitude and timing of cash flows.

– Why cash flows?

– Why not earnings measures?

The University of Sydney Page 3

 Firm vs. Equity Valuation
– Free cash flows (FCF) represent the cash available for distribution to all stakeholders of the firm.
– Therefore, operating cash flow less capital expenditures and non cash working capital.
– It is the residual cash flow after all expenses necessary to keep the firm growing at its current rate.

– Free Cash flow to the Firm (FCFF): is the cash flow available to the company’s suppliers of capital after
all operating expenses have been paid and necessary investments in working capital and fixed capital have
been made.

– Free Cash flow to Equity (FCFE): is the cash flow available to the company’s common equity holders
after all operating expenses have been paid and necessary investments in working and fixed capital have
been made.

– FCFE can be calculated by subtracting the value of non-common stock capital (usually debt and preferred
stock) from FCFF.

The University of Sydney Page 4

 Free Cash Flow

Free Cash Flow to the Free Cash Flow to

Firm Equity
= Cash flow available
= Cash flow available to
to common
common stockholders
stockholders

Debtholders

Preferred stockholders

The University of Sydney Page 5

 Free Cash Flow to Equity (FCFE)
– The FCFE model is not a radical departure from the traditional dividend discount
model.
• The primary difference between models lay in the definition of cash flows.
• DDM = potential dividends paid (depends on firm’s dividend policy).
• FCFE = actual dividends paid.

– When firms pay dividends ≠ FCFE, the values from the two models will be
different.
• More common that value from FCFE model > DMM model.
• Which is more appropriate for valuation?

The
The University
University of
of Sydney
Sydney Page 6
 Free Cash Flow to Equity (FCFE)
Use the Dividend Discount Model (Gordon):

a) For firms which pay dividends (and repurchase stock) which are close to the FCFE (over an
extended period).
b) For firms where FCFE are difficult to estimate (e.g. Banks and Financial Service
companies).

Use the FCFE Model:

c) For firms which pay dividends which are significantly higher or lower than the FCFE.
d) For firms where dividends are not available (IPO’s, private companies).

The
The University
University of
of Sydney
Sydney Page 7
 Calculating FCFE – Unlevered Firm

FCFEUnlevered Firm = EBIT(1 - T) + DA -WC –CAPEX

Since interest expense = 0

FCFEUnlevered Firm = NI + DA – WC – CAPEX

EBIT: Earnings before interest and taxes

EBIT(1 - T): After-tax operating income or net operating profit after tax (NOPAT)
T: Tax rate
DA: Depreciation and amortisation expense
WC: Change in net working capital
CAPEX: Capital expenditures for property, plant, and equipment
NI: Net Income
The
The University
University of
of Sydney
Sydney Page 8
 Components of FCFE - Earnings
– A company’s accounting earnings are not unrelated to its free cash flow.
– Earnings are the result of taking the cash flows generated by a firm’s operating and investing
activities, and accruing or deferring certain cash flows to earlier or later periods.

– These accruals and deferrals are designed to facilitate performance evaluation, rather than to
obfuscate the analysis of free cash flow.

– To the extent that we start with accounting earnings in a base year, it is worth considering the
following questions:
– Are there any one-time charges that might be depressing income in the base year or one-time
earnings that might be increasing income in the base year?
– Are the earnings negative, and if so, why?
– Are there any financial or capital expenses intermingled with operating expenses?

The University of Sydney Page 9

 Components of FCFE - Non-Cash Charges

– Depreciation and Amortisation expense (DA)

– Does not represent an actual cash payment

– Arises out of the matching principle of accrual accounting, matches expenditures made for
long-lived assets (plant, machinery and equipment) against the revenues they help generate.

– The actual expenditure of cash may have taken place many years earlier when the assets were
acquired.

– Other items like Restructuring expense (subtracted out), capital gains (subtracted out),
employee option exercise (added back), deferred taxes (added back).
The
The University
University of
of Sydney
Sydney Page 10
 Components of FCFE – Net Capital Expenditures (CAPEX)

– Net capital expenditures sustain productive capacity and provide for growth firms invest in
long-lived assets
• Maintenance CAPEX: Assets physically wear out and need replacement
• Growth CAPEX: To achieve growth in future cash flows firms require added
capacity through investments in new PPE and acquisitions of businesses

– CAPEX can be calculated by analysing how net PPE on the balance sheet changes over time
• Net property, plant, and equipment is equal to the difference in the accumulated cost
of all property, plant, and equipment (gross PPE) less the accumulated depreciation
for those assets
– e.g. CAPEX(2007) = Net PPE (2007) – Net PPE(2006) + Depn Expense (2007)

The
The University
University of
of Sydney
Sydney Page 11
 Components of FCFE – Net Capital Expenditures (CAPEX)

– In general, net CAPEX will be a function of how fast a firm is growing, or

expected to grow.
– High growth firms will have much higher net capital expenditures than low growth firms.

– Remember product life cycle.

– Assumptions about net capital expenditures should NEVER be made

independently of assumptions about growth in the future.

The University of Sydney Page 12

 Components of FCFE – Change in Working Capital
– In accounting terms, working capital (WC) is the difference between current assets and current liabilities where:
– Current Assets = inventory, cash, accounts receivable
– Current Liabilities = short term debt, current portion of long term debt, accounts payable

– In finance, we use a simpler approach whereby WC is the difference between non-cash current assets and non-
debt current liabilities.
– Current Assets = inventory, accounts receivable
– Current Liabilities = accounts payable

– Any investment in this measure of working capital ties up cash. Therefore, any increase (decrease) in working
capital will reduce (increase) cash flows in that period.

– When forecasting future growth, it is important to forecast the effects of such growth on working capital needs,
and building these effects into the cash flows.

The University of Sydney Page 13

 Components of FCFE – Change in Working Capital
– Changes in net working capital (WC)1
– Investments in current assets used in a firm’s
operations are partially financed by increases in
current liabilities

– The end result is an outlay for working capital

equal to the change in operating net working
capital

– We may not want to always exclude cash and

marketable securities because some firm
require liquidity to support operations/growth. 1
Referred to as “change” rather than “increase” since the change can be both positive and negative.

The
The University
University of
of Sydney
Sydney Page 14
 Calculating FCFE – Levered Firm

FCFE = (EBIT-I)(1 - T) + DA - CAPEX - WC – P + NP

Which is the same as:
FCFE = NI + DA – CAPEX – WC – P + NP

– (EBIT – I)(1 - T): Net income after taxes

– NI: Net Income
– P: Principal payments on the firm’s outstanding debt
– NP: Net proceeds from the issuance of new debt
– When a firm uses debt the two cash flow consequences are net proceeds (inflow) and
cash outlays for principal and interest payments. Since interest expense is tax
deductible, it reduces the taxes the firm has to pay.

The University of Sydney Page 15

 What impact does borrowing have on FCFE?
– Borrowing to finance an investment results in financial leverage
– This will generally have some impact on the interest tax shield and reduce the cash flow
available to equity.
– Therefore the risk of uncertain cash flows must be absorbed by the equity holders.
– Because of the higher risk, shareholders require higher rates of return to entice them to
invest in levered projects

– In summary, you can continue to borrow (hence increase leverage) which will
pump up your FCFE but at the other end of the ledger your levered beta will
increase thereby generating a higher discount rate.

– Dividends and share repurchases are uses of these cash flows so do not affect free
cash flow.
The University of Sydney Page 16
 Calculating FCFF
– Combines the cash flow available for distribution to all the firm’s sources of
capital.
FCFF = EBIT(1-T) + DA – WC – CAPEX
Where are the tax-savings from interest payments in this cash flow?
This can also be expressed in the following way:

FCFF = NI + DA + Interest(1- Tax Rate) – WC – CAPEX

Where;
NI = (EBIT-Interest)*(1-Tax Rate) = EBIT(1-Tax Rate) – Interest (1-Tax Rate)

The University of Sydney Page 17

 Computing FCFF from the Statement of Cash Flows
– Analysts frequently use cash flow from operations, taken from the statement of
cash flows, as a starting point to compute free cash flow because cash flow from
operations (CFO) incorporates adjustments for expenses (such as depreciation and
amortisation) as well as for net investments in working capital.

– Cash flow statements may be useful to the end user because for such items like
interest expense they allow the company to classify it as either an operating or
financing activity.

– To estimate FCFF by starting with CFO:

FCFF = CFO + Interest(1-Tax Rate) - FCInv

The University of Sydney Page 18

 Equity v Firm Valuation
Use Equity Valuation:
a) For firms which have stable leverage, whether high or not, and
b) If equity (stock) is being valued.

Use Firm Valuation:

c) For firms which have leverage which is too high or too low, and expect to change leverage
over time.
– This is because debt payments and issues do not have to be factored in the cash flows and the discount rate (cost of
capital) does not change dramatically over time.
d) For firms where you may have partial information on leverage (e.g. interest expenses are
missing).
e) In all other cases where you are interested in valuing the firm (i.e. value consulting).

The
The University
University of
of Sydney
Sydney Page 19
Terminal Value:
Closing out your Valuation

The University of Sydney Page 20

 Learning Objectives
– What is terminal (continuing) value?

– How do we determine the length of the forecast horizon?

– What are the different ways of estimating terminal value?

– What is a reasonable growth rate?

– What are some alternative ways of thinking about the growth rate?

The University of Sydney Page 21

 Closing out a Valuation
– A publicly traded firm is assumed to have an indefinite life. The value is therefore equal to the present value of
its future cash flows.

– In other words: CFt


t 
Value 
t 1
(1  r)t

– Since we cannot estimate cash flows forever, we estimate cash flows for a growth period and then estimate a
terminal value to capture the value at the end of the period.

CFt TV

tN
Value  t

t 1
(1  r) (1  r)t

– We are therefore making simplifying assummptions about a firm’s performance (constant rate of growth on
existing and new capital)

The University of Sydney Page 22

 In other words...
• To estimate a company’s value, we separate a
company’s expected cash flow into two periods
and define the company’s value as follows:

12,000

Present Value of Cash Flow

10,000
during Explicit Forecast Period
8,000

$ million
Value = 6,000

Present Value of Cash Flow

4,000
after Explicit Forecast Period
2,000

0
• The second term is the continuing value: the 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

value of the company’s expected cash flow

Explicit Forecast Continuing
beyond the explicit forecast period. Period Value

The University of Sydney Page 23

 Terminal (Continuing) Value

– We prioritise the terminal value because it represents a sizeable portion of any valuation analysis.
– In the same way that non-current assets (fixed assets) make up a significant proportion of total assets, so
does the terminal value for an intrinsic valuation.

– We should be careful not to prioritise the terminal value over the forecast horizon valuation because
it constitutes a bigger proportion of the valuation. There are at least two reasons for this:
– Estimates of continuing value depend on decisions and assumptions made in the earlier period.
– A larger continuing value does not mean that more value has been created in this period; rather it just
means that the amount of economic profit generated in the period is higher than in the forecast horizon
period.
• If our cash inflows in the short-term are offset by investment in fixed assets (cash outflows in the
same period), then our future cash-flows, and hence our continuing value is a function of the building
blocks we put in place during the forecast horizon period.
The University of Sydney Page 24
 How do we estimate Terminal Value?
– Terminal Value can be estimated a number of ways. The most common approaches
include:

1. Stable Growth Model

 This method requires you to make a judgement about when a firm will grow at a stable rate
for which it will need to sustain.
2. Multiple Approach
 Easiest approach but makes the valuation a relative one.
3. Liquidation Value
 Most useful when assets are separable and marketable.

The University of Sydney Page 25

 How to get the “right” terminal value

1. Select a reasonable growth rate

2. Select a reasonable forecast horizon

3. Think about the return on invested capital

4. Be consistent in your model

The University of Sydney Page 26

 Selecting a reasonable growth rate
– The stable growth rate cannot exceed the growth rate of the economy.

– How much lower, if at all?

– This is a subjective question, but as a guide:
• If the economy consists of high growth and stable growth firms then the growth rate
of the latter group will probably be less than the growth rate of the economy.
• The stable growth rate can be negative.

– If you are using nominal cash flows and a nominal discount rate then be sure to
also use a nominal growth rate.
– Using the risk free rate is a simple and suitable proxy for this estimate.

The University of Sydney Page 27

 Some points of clarification
– Reaching a ‘steady state’ causes all sorts of confusion
– Does this mean that a company ceases to earn in excess of the cost of
capital or is it simply confined to new investment.

– Example?

The University of Sydney Page 28

 Time – Are all forecast horizon periods the same?
– The explicit forecast period must be long enough for the company to reach a steady
state, defined by the following characteristics:
– The company grows at a constant rate and reinvests a constant proportion of its operating profits into the business each
year.
– The company earns a constant rate of return on new capital invested.
– The company earns a constant return on its base level of invested capital.

– In general, an explicit forecast period of 5-10 years is generally recommended —

perhaps longer for cyclical companies or those experiencing very rapid growth.
– Using a short explicit forecast period, such as five years, typically results in a significant undervaluation of a company
or requires heroic long-term growth assumptions in the continuing value.

– We should also remember to undertake a qualitative assessment.

– Porter’s 5 forces, SWOT analysis.

The University of Sydney Page 29

 Gray, Cusatis, Woolridge (GCW, 1999)
– Set T = 1 year for ‘boring companies’ which (1) operate in highly competitive, low
margin industries and (2) ‘have nothing particular going for them.

– Set T = 5 years for ‘decent companies’ with reasonable reputations and propsects.

– Set T = 7 years for ‘good companies’ with good growth potential, brand names,
marketing channels, consumer recognition, or some other recongisable competitive
advantage.

– Set T = 10 years for ‘great companies’ with substantial competitive advantages like
strong marketing power, brand names, or technology.

The University of Sydney Page 30

 Think about the make-up of growth rates
– Growth rate can be determined in the following way:

Growth Rate = Reinvestment Rate * Return on Invested Capital

+ Growth Rate from Improved Efficiency

– In stable growth, you cannot count on efficiency delivering growth and you have to re-invest
to deliver the growth rate that you have forecast.
– Therefore, your reinvestment rate in stable growth will be a function of your stable growth rate and
what you believe the firm will earn as a return on capital in perpetuity.

– There is much contention about this issue.

• Some prominent authors have taken the position that the return on capital cannot exceed the
cost of capital forever.

The University of Sydney Page 31

 Looking forward
– There is always going to be forecast error (uncertainty)
associated with our estimates.
– Certain industries and firms will be more volatile.
– How do we handle this volatility from a valuation perspective?

– Project/Firm Risk Analysis

– Includes sensitivity, scenario, simulation analysis
– What do we learn from this type of analysis?

The University of Sydney Page 32