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FIN 468: Intermediate Corporate Finance
Topic 5–Free Cash Flow
Larry Schrenk, Instructor
Exam 1 Structure
Length 1 hour Format 100 Points
Short Answer 50 Points (10 Questions)
Calculations 50 Points (5-8 Questions) Materials Financial Calculator
No Crib Sheets, Formulae Sheets, etc. You only need to know the formulae for ratios
mentioned on slides or discussed in class.
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Exam Short Answer Preparation
Slides and Notes Main Ideas
Textbook Main Ideas Learning Outcomes Bold Terms Chapter Summaries EoC Problems: Conceptual Issues
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Exam Calculation Preparation
Slides and Notes Main Calculations
Textbook Calculations in Text EoC Problems: Calculations
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Topics
Why Free Cash Flow (FCF)?
The Free Cash Flow Method
Problems with Free Cash Flow
Free Cash Flow Example
Dividends versus FCF
Dividends Cash Flows Actually Paid to Stockholders
Free Cash Flows Cash Flows Available for Distribution
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Problems with DDM
Distribution, not Creation, of Value Arbitrary and Hard to Predict Retained Earnings Problem Much Value Far in the Future Cannot use to Value Firm Agency Issues
Cash flows should reflect ability to pay dividends, not what was actually paid
FCF Situations
No Dividends
Dividend Differ from Capacity to Pay
Free Cash Flows Align with Profitability
Control Perspective
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Free Cash Flow
Free Cash Flow = Cash Flow Available Available???
No Definition Like Ratios
Theoretical, not Observable, Value
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FCFF versus FCFE
Free Cash Flow–Firm (FCFF) Enterprise Cash Flow Value the Entire Firm
Free Cash Flow–Equity (FCFE) Value Equity Issue: Preferred Shares
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Free Cash Flow–Firm (FCFF)
Cash Flow Available to… Repay Lenders Pay Common and Preferred Dividends Repurchase Equity Call Debt
Adjustments to Net Income Interest and Principal Payments Non-Cash Items Δ Working Capital Δ Capital Expenditures
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Free Cash Flow–Firm (FCFF)
Net Income
+ Interest and Principal Payments
+ Non-Cash Items (e.g., Depreciation)
– ΔNet Working Capital
– Δ Capital Expenditures
FCFF
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Free Cash Flow–Equity (FCFE)
Cash Flow Available to… Repay Lenders Pay Common and Preferred Dividends Repurchase Equity
Adjustments to Net Income Interest and Principal Payments Non-Cash Items Δ Working Capital Δ Capital Expenditures
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Free Cash Flow–Equity (FCFE)
Net Income
+ Non-Cash Items (e.g., Depreciation)
– ΔNet Working Capital
– Δ Capital Expenditures
FCFE
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Alternate FCFE Method
Derive Value form FCFF
FCFF
– Value of Debt
FCFE
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Possible CF Growth Patterns
FCF Constant No-Growth Assumption
FCF Changing at Constant Rate Constant Growth Assumption
Neither Variable Growth Assumption
The Cash Flows
The Income Statement Net Income Use This Method
The Statement of Cash Flows Cash Flow from Operations
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Interest and Principal Payments
After Tax Interest Payment Interest x (1 – tc)
Principal Repayment? Target Capital Structure
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Non-Cash Adjustments
Non-Cash Item Adjustment to Net Income
Depreciation Added Back
Amortization of intangibles Added Back
Restructuring Charges (expense) Added Back
Losses Added Back
Gains Subtracted
Amortization of long-term bond discounts Added Back
Amortization of long-term bond premium Subtracted
Deferred Taxes None
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Forecasting Cash Flows
Historical Data Historical Growth Rate Best for Constant Growth Past Predictive of Future
New Information
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Forecasting Capital Expenditures
Two Components Net Expenditures to Maintain Assets-in-Place
New Expenditures to Support Growth Opportunities
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Terminal value
Firms are Infinite
Perpetuity or Growing Perpetuity
WARNING: Delayed Perpetuity
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Discount Rate
FCFF WACC
FCFE Required Return on Equity
More in Cost of Capital
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Problems with Free Cash Flow
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Technical Problems
Free cash flow forecasts are generally not available
Generally must compute statement of cash flows from: earnings forecasts balance sheet assumptions
Much of value comes far in the future
Capital Expenditures
“Cash flow available to the firm’s suppliers of capital after all operating expenses have been paid and necessary investments in working capital and fixed capital have been made.”
What is ‘necessary’?”
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Income Statement
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Revenues $644,400,000Costs and operating expenses Cost of product sales $294,200,000 Selling, general and administrative $92,900,000 Depreciation and amortization $20,000,000 Research and development $44,400,000 Bad debt provisions $200,000Total costs and operating expenses $451,700,000Operating income $192,700,000Other income (expense) Interest income $15,900,000 Interest expense ($11,300,000)
Other $700,000Total other income (expense) $5,300,000Income before tax $198,000,000Income tax provisions $74,000,000Net income $124,000,000Dividends $24,000,000
Income Statement
Parameters
Rates WACC 12% Return on Equity 17%
Adjustments ΔNet Working Capital $5,000,000 ΔCapital Expenditures $35,000,000
Growth Rates g1-4 20% g5+ 2%
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Initial FCFF
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Interest and Principal Payments $7,076,768 +Depreciation $20,000,000 +D Net Working Capital $5,000,000 –D Capital Expenditures $35,000,000 –
FCFF 111,076,768
FCFF
Note: Interest and Principal Payments are After-Tax
FCFF Valuation
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1 2 3 4 5+Growth 20% 20% 20% 20% 2%FCFF $133,292,121 $159,950,545 $191,940,655 $230,328,785 $234,935,361Terminal Value $2,349,353,612PV (Annual) $119,010,823 $127,511,596 $136,619,567 $146,378,107 $1,493,056,693PV (ST) $529,520,092PV (LT) $1,493,056,693Value $2,022,576,785
FCFF Model
Initial FCFE
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Depreciation $20,000,000 +D Net Working Capital $5,000,000 –D Capital Expenditures $35,000,000 –
FCFF $104,000,000
FCFE
FCFE Valuation
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1 2 3 4 5+Growth 20% 20% 20% 20% 2%FCFF $124,800,000 $149,760,000 $179,712,000 $215,654,400 $219,967,488Terminal Value $1,466,449,920PV (Annual) $106,666,667 $109,401,709 $112,206,881 $115,083,981 $782,571,071PV (ST) $443,359,238
PV (LT) $782,571,071Value $1,225,930,309
FCFE Model
