Reading 47: Free Cash Flow Valuation

I finished doing this Reading from Schweser and the Curriculum combined. Schweser has actually done a good job on this one. I am yet to work out the Chapter End Problems though. I'll do that tomorrow.

Some useful concepts:

1. FCFF and FCFE are the cash flows available to all of the investors in the company and to common stock holders, respectively.

2. Analysts like to use free cash flow as return (either FCFF or FCFE) when-

• the company is not dividend paying
• the company is dividend paying, but the dividend stream differs a lot from the company's dividend paying capacity
• if FCFs align with profitability within a reasonable forecast period with which the analyst is comfortable; or
• if the investor takes a control perspective (as in the case of mergers and acquisitions).

3. FCFF is preferred if the company is unstable or has huge amount of debt because the FCFE might be very low or negative in this case. FCFE is used if the company is stable and mature.

4. Some important formulas that we need to memorize:

FCFF= NI+ NCC+(Int(1-Tax Rate))-FCInv-WCInv

FCFF=EBIT(1-t)+Depr-FCInv-WCInv

FCFF=EBITDA(1-t)+(Depr*t)-FCInv-WCInv

FCFF=CFO+Int(1-t)-FCInv

FCFE=FCFF-(Int(1-t)+net borrowing

FCFE=NI+NCC-FCInc-WCInv+Net Borrowing

FCFE=CFO-FCInv+Net Borrowing

For forecasting FCFE, we use=NI-[(1-DR)*(FCinv-Dep)]-[(1-DR)*WCInv], where DR= % of Debt Financing

Working Capital Investments exclude cash, cash equivalents, notes payable and the short term part of the long term debt.

NCC includes Depreciation, Amortization, Gains (-), Losses (+), Restructuring Costs (+ if expenses), restructuring costs (income resulting from reversal should be subtracted), amortization of bond discount should be added and amortization of bond premium needs to be subtracted.

5. Earning components such as net income, EBIT, EBITDA and CFO should not be used as cash flow measures to value a firm. These earnings components either double count or ignore parts of the cash flow stream.

6. The revelant discount rate for FCFF is WACC and for FCFE, it is the cost of equity.

7. Dividends, share repurchases, and share issues have no effect on FCFF/FCFE. Only the change in the debt amount has some effect on the FCFE. When we retire debt, then initially FCFE falls, then in later years, it increases because of the reduction in interest expense.

8. We can calculate FCFF/FCFE using One stage, Two stage or three stage discount models, where the future cash flow streams are discounted at the appropriate discount rate.

9. The terminal value can be calculated in two ways- Using the single stage or multiple stage approach. Or using a valuation multiple such as trailing or leading P/E multiplied by the Earnings estimate.