21 Free Cash Flow Flashcards
firm value =
FCFF discounted at the WACC
equity value =
= FCFE discounted at the required return on equity
Analysts often prefer to use free cash flow rather than dividend-based valuation for the following reasons:
no, or low, cash dividends.
Dividends may be poorly aligned with the firm’s long-run profitability.
If a company is viewed as an acquisition target
Free cash flows may be more related to long-run profitability of the firm as compared to dividends.
Calculating FCFF from net income
FCFF = NI + NCC + [Int × (1 − tax rate)] − FCInv − WCInv
FCInv =
FCInv = capital expenditures − proceeds from sales of long-term assets
FCInv = ending net PP&E − beginning net PP&E + depreciation
Example: Calculating FCInv with long-term asset sales
Suppose that Airbrush reports capital expenditures of $1,400, long-term asset sales of $600, and depreciation expense of $850. The long-term assets sold were fully depreciated. Calculate Airbrush’s revised FCInv for 2023.
Working capital investment
change in working capital, excluding cash, cash equivalents, notes payable, and the current portion of long-term debt
Calculating FCFF from EBIT.
FCFF = [EBIT × (1 − tax rate)] + Dep − FCInv − WCInv
Calculating FCFF from EBITDA.
FCFF = [EBITDA × (1 − tax rate)] + (Dep × tax rate) − FCInv − WCInv
Calculating FCFF from CFO
FCFF = CFO + [Int × (1 − tax rate)] − FCInv
Calculating FCFE from FCFF.
FCFE = FCFF − [Int × (1 − tax rate)] + net borrowing
where:
net borrowing = long- and short-term new debt issues − long- and short-term debt repayments
Calculating FCFE from net income.
FCFE = NI + NCC − FCInv − WCInv + net borrowing
Calculating FCFE from CFO.
FCFE = CFO − FCInv + net borrowing
Explain how dividends, share repurchases, share issues, and changes in leverage may affect future FCFF and FCFE.
The short answer is that dividends, share repurchases, and share issues have no effect on FCFF and FCFE; changes in leverage have only a minor effect on FCFE and no effect on FCFF.
Single-Stage FCFF Model
Single-Stage FCFE Model
Example: Calculating firm value with a single-stage FCFF model
Knappa Valley Winery’s (KVW) most recent FCFF is $5,000,000. KVW’s target debt-to-equity ratio is 0.25. The market value of the firm’s debt is $10,000,000, and KVW has 2,000,000 shares of common stock outstanding. The firm’s tax rate is 40%, the shareholders require a return of 16% on their investment, the firm’s before-tax cost of debt is 8%, and the expected long-term growth rate in FCFF is 5%. Calculate the value of the firm and the value per share of the equity.
Example: Calculating value with a single-stage FCFE model
Ridgeway Construction has an FCFE of 2.50 Canadian dollars (C$) per share and is currently operating at a target debt-to-equity ratio of 0.4. The expected return on the market is 9%, the risk-free rate is 4%, and Ridgeway has a beta of 1.5. The expected growth rate of FCFE is 4.5%. Calculate the value of Ridgeway stock.
