Chapter 4 Free Cash Flows to Equity Frim

7/27/2019 Chapter 4 Free Cash Flows to Equity Frim

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Free cash flows to equity/firm

Chapter -4

free cash flows to equity/ frim1


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Learning Objectives

Introduction

Forecasting FCFE/FCFF

Equity of cost of capital



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Valuing the Firm

Economic theory teaches us that the value of an

investment is:


Expected future payoffs can be measured in

terms of:

Dividends Cash Flows

Earnings

n

t t

tV1

0

Rate)Discount(1

PayoffsFutureProjected


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Approaches to firm valuation



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Focus is on the cash that flows into the firm.

Measures the cash flows that are free to be

distributed to shareholders. Cash flows generated by the firm create

dividend-paying capacity.


Cash-Flow-Based Valuation


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Amount of cash flowing into firm differs from

dividends paid in a particular period.

But over the lifetime of the firm, cash flowsinto and cash flows out of the firm will be

equal.


Cash-Flow-Based Valuation (Contd.)


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Cash is the ultimate source of value. The

free cash flows approach measures value

based on the cash flows that the firmgenerates that can be distributed to

investors.

It is a measurable common denominatorfor comparing the future benefits of

alternative investment instruments.


Rationale for Using Free-Cash-Flows


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Cost of Common Equity Capital

CAPM Model:


portfoliomarketwideonreturnRequired

jfirmforbetaMarketreturnofratefree-Risk

jfirminequitycommononreturnRequired

nexpectatio

:Where

M

j

F

Ej

FMjFEj

R

R

R

E

]}]E[R{E[R]E[R]E[R


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Weighted Average Cost of Capital


costsdebttoapplicablerateisrateTaxcapitaloftypeeachofproportionisw

capitaloftypeeachofcostisR

:Where1

1

EPD

EEPPDDA

www

]R[w]R[w]tax rate)(R[wR


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Measuring Free Cash Flows

Under U.S. GAAP and IFRS, Cash flow

statement categorize the activities as

operating, investing and financing. Some rearrangements are necessary to

compute free cash flows.



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Measuring Free Cash Flows (Contd.)

Cash flow from operations from the

projected statement of cash flows is the most

direct starting point because it requires thefewest adjustments.

However, some analysts compute free cash

flows using alternative starting points.



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Free Cash Flows for All Debt and Equity Stakeholders:

Operating Activities:Cash Flow from Operations

+/-Net Interest after Tax+/-Changes in Cash Requirements for Liquidity

= Free Cash Flows from Operations for All Debt and Equity

Investing Activities:+/-Net Capital Expenditures

= Free Cash Flows for All Debt and Equity Stakeholders



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Free Cash Flows for Common Equity Shareholders:

Operating Activities:Cash Flow from Operations

+/-Changes in Cash Requirements for Liquidity= Free Cash Flows from Operations for Equity

Investing Activities:+/- Net Capital Expenditures

Financing Activities:+/- Debt Cash Flows

+/- Financial Asset Cash Flows

+/- Preferred Stock Cash Flows

= Free Cash Flows for Common Equity Stakeholders



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Cash-Flows-Based Valuation Models

To value common equity measure:

Discount rateRE.

Expected future free cash flowsFCFEq forperiods 1 through Tover forecast horizon.

Continuing free cash flows, FCFEq(T+1), and long-

run growth rate, g.



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Free-Cash-Flows-Based Valuation Models

For common equity shareholders:


rateGrowth

capitalequityonreturnofrateRequired

rsshareholdeequitycommonforflowscashFree

firmaofequitycommontheofvaluePresent

Where,

g

R

FCFE

V

])R/([g)]/(R[][FCFE)R(

FCFEV

E

T

t

T

EETtE

t

0

1

10111

1


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Free-Cash-Flows-Based Valuation Models

For all debt and equity capital stakeholders:


rateGrowth

capitalofcostaverageweightedfutureExpected

rsstakeholdecapitalequityanddebtallforflowscashFree

firmaofassetsoperatingnetofvaluePresent

Where,

g

R

FCFA

VNOA

])R/([g)]/(R[][FCFA

)R(

FCFAVNOA

A

T

t

T

AATt

A

t

0

1

10111

1


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Continuing Value

Represented by last term of equation:

Use expected long-term growth rate, g, to

project all items on Year T+1 income

statement and balance sheet. RAmust be greater than g for this formula to

work.


])R/([g)]/(R[][FCFA T

AAT

1111


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What now?

Once valuation model is applied, then

Conduct sensitivity analysis:

Vary cost of equity capital rate (RE)

Vary long-run growth rate (g)

Discount rate assumptions

Vary these parameters and assumptionsindividually and jointly.



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Evaluation of the Free-Cash-Flows-Valuation method

Advantages:

Focuses on free cash flows, believed to

have more economic meaning thanearnings.

Results from projections of futureoperating, investing, and financing

decisions of a firm made by the analyst.



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Advantages: (Contd.)

Focuses directly on net cash inflows

available to be distributed to capitalproviders. This perspective is especiallypertinent to acquisition decisions.

Widely used in practice.



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Disadvantages:

Can be time-consuming making it costly.

Continuing value tends to dominate the totalvalue but is sensitive to assumptions growthrates and discount rates.

Free cash flow computations must be

internally consistent with long-runassumptions regarding growth and payout.And is affected by estimation errors.



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Learning Outcomes

Measurement of cost of capital

Cost of debt

Security valuation


Documents

Chapter 4 Free Cash Flows to Equity Frim