Chapter 10

Firm valuation: the DCF approach (using free cash flow)

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I. Basic Process :
• Stock value = Total equity value / number of shares

• Total equity value = Total firm (Entreprise) value – Net financial Debt

• Total firm (Entreprise) value = operating value + total value of non

operating assets

• Total value of non operating assets = their potential selling price

• Operating value = the present value of operating cash flows (free cash
flow) to be received at perpetuity

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II. Explanation of the basic process:

• In finance, the operating value of an asset depends on its ability

to generate future cash flows.

• The operating value of a company depends on its ability to

generate future cash flows.

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 After tax operating income (which is
also equat to :
NI + Int(1-T)
(See the next slide)

Free cash flow tothe firm (FCFF)

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NB:
We know that : NI = (operating income - Int) (1-T)
• NI = operating income (1-T) - Int (1-T)
• operating income (1-T) = NI + Int (1-T)

With :
• NI: Net income
• T: Tax rate
• Int: Interest expense

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 NB: Measuring the NWK of the company at a given
date
Intuition: For new projects, I0 represents the total of investment sources. It is supposed to
finance the operating long term assets and the NWK (wich is an operating NWK). The total
amount of I0 should be invested in these former items, and therefore, it is recommended to
avoid investing in excess cash (sleeping money generates an opportunity cost) and in assets
that are not needed for the project (non operating assets).

I0 = Long lived assets + operating NWK

For already existing companies, I0 represents the total amount of investments, so it could be also
considered = Equity + Total financial debt

However, in most cases, these sources finance some excess cash and other non operating
assets, therefore, for already existing companies:

I0 = Long lived operating assets + operating NWK + excess cash + other non operating assets
Operating NWK = I0 – Long lived operating assets assets – excess cash – other non operating
assets
I0 = Equity + Total debt
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Operating NWK = Equity + Total financial debt – Long lived operating assets –excess cash
From the basic accounting equation, we know that:

Equity + total financial debt + accounts payable + accruals and other current
operating liabilities = long lived operating assets + inventories + accounts
receivable and other current operating assets + excess cash+ other non operating
assets Operating NWK according to equation
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So,

Equity + Total financial debt – Long lived operating assets –excess cash –
other non operating assets =
inventories + accounts receivable and other current operating assets– accounts
payable – accruals and other current operating liabilities

Operating NWK = inventories + accounts receivable and other current

operating assets – accounts payable – accruals and other current operating
liabilities

This formula is used whenever the analyst would like to measure the operating
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NWK of the company at a given date!
How to find net Capex for a given period (year):

• Long lived assets (Net value at the end of the year)

= long lived assets (Net value at the beginning of the year) + New
acquisitions of LL assets – Sales of LL assets - annual depreciations of LL
assets

Net Capex

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• Long lived assets (Net value at the end of the year)
= long lived assets (Net value at the beginning of the year) + Net
Capex - annual depreciations

Net CAPEX = Long lived assets (Net value at the end of the
period) - long lived assets (Net value at the beginning of the
period) + Annual depreciations

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III- Practice problems:

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