Free Cash Flow to Capital Calculation

Adding-back depreciation and subtracting CAPX is the same as

simply deducting net PPE
Subtracting reported taxes and adding-back Deferred Tax is the
same as subtracting cash taxes
T-Bill Yield = Risk free rate
Single A bond Yield = Cost of debt = rd
While forecasting NWC apply Sales growth rate
Unlever / Relever beta: for the purpose of this course, it is OK to assume debt beta = 0. A
lot of you asked me why the formula in Professor Rock's slides is different from the ones
you've seen from other courses, and the reason is that we assume debt is safe (i.e.
investment grade) and the firm is not highly levered / distressed.
Whether to use cost of debt or cost of unlevered equity when discounting PVITS in APV
method - I think which discount rate should be applied depends on how you justify the
risks associated with PVITS. Using cost of debt or cost of unlevered equity implies
different degree of risks. The simple approach (i.e. using cost of unlevered equity) is
more conservative as the higher rate generates a lower present value. Depending on the
situation, it is up to you to make a compelling case to justify which rate is more
appropriate to use.
Difference between a) ROExRetention and b) NRRxROTC: the former is more restrictive
than the later because it assumes the only source of equity is retained earnings. The later,
in contrast, is more flexible because it allows a firm to fund growth with external capital.
b) says that when a firm has a stable return on total capital (ROTC), its expected growth
in operating income (EBIAT) is a product of the reinvestment rate (NRR, i.e., the
proportion of the after-tax operating income that is invested in net capital expenditures
and non-cash working capital), and the quality of these reinvestments (ROTC).
Tax expense / cash taxes / deferred taxes: deferred taxes arise from temporary differences
between tax expense (GAAP accounting) and cash taxes (Tax accounting, or think IRS).
Common examples of temporary differences include different depreciation schedules
(e.g. Dynatronics) and gains / losses on assets sales (e.g. Hardy's Woods).This holds true
even when a company has negative taxable income. For example, if Company A has a
pretax loss of $100 and tax rate of 40%, it will record a negative tax expense of $40 on
the income statement, and book a $40 DTA on balance sheet, which means it pays 0 in
cash taxes and has a tax credit of $40. Please refer to accounting course materials /
textbook if you want further details on deferred taxes.
Given the high volume of emails that I've been receiving and the fact that I'm in the
middle of final exams this week, please be patient if you do not hear back from me
immediately. I will try my best to address your questions at the review session on Friday.

For the exam

There are three different methods to calculate FCFCapital
1. CAPM
2. FCFEquity Method
3. Using APV. ( This will not be in the exam)
FCF to capital = EBIT ( 1 t ) + depreciation + Goodwill CAPx - NWC + Deferred
Taxes + Other
Net PP&E = Opening PP&E Closing PP&E = Dep + Capx
NWC = CA CL (Excess Cash Int. Bearing Debt )
1.
Calculate FCF using CAPM
For FCFCaptial =
Step 1 - EBIAT = EBIT ( 1 t )
Step 2 Add depreciation
- Add change in goodwill + Goodwill
Step3 Subtract
- Capx
- NWC: in current Asset - Current Liabilities Excess Cash if any
2.
Calculate FCF using FCFEquity
Net Cash Flow
+ Int ( 1 t )
- Debt
3. Current capital structure
# of shares outstanding * share price = E
Net Debt = D
%E = E/(D+E)
4. Un-lever Measured Beta using current capital structure
Bunlever = Meansured Beta * %E
Lever using new %E calculate using Shareholder equity / Total capital
Blever = Bunlever / new %E
5. Calculate rE
rE = rF + B (rM rF)
6. WACC = D/(D+E) * rd * ( 1 t ) + E/(D+E) * re

Here Debt is Net Debt ( gross debt current Debt ) ; D+E is the enterprise value
PV = Discounted FCF with WACC + discounted TV with WACC
n

FCF i/(1+WACC )i
i=0

TV / (1+WACC)n