FREE CASH FLOWS

Intro to Free Cash Flows

Dividends

are the cash flows actually paid

to stockholders
Free cash flows are the cash flows
available for distribution.
Applied to dividends, the DCF model is
the discounted dividend approach or
dividend discount model (DDM). This
chapter extends DCF analysis to value a
firm and the firms equity securities by
valuing its free cash flow to the firm
(FCFF) and free cash flow to equity
(FCFE).

Intro to Free Cash Flows

Analysts

like to use free cash flow valuation

models (FCFF or FCFE) whenever one or
more of the following conditions are present:
the firm is not dividend paying,
the firm is dividend paying but dividends differ
significantly from the firms capacity to pay dividends,
free cash flows align with profitability within a
reasonable forecast period with which the analyst is
comfortable, or
the investor takes a control perspective.

Intro to Free Cash Flows

Common

equity can be valued by

either
directly using FCFE or
indirectly by first computing the
value of the firm using a FCFF model
and subtracting the value of noncommon stock capital (usually debt
and preferred stock) to arrive at the
value of equity.

Defining Free Cash Flow

Valuing FCFE
The

value of equity can also be found by discounting

FCFE at the required rate of return on equity (r):

FCFE t
Value

Since FCFEEquity
t
is the cash flow (1
remaining
for equity

r
)
t 1

holders after all other claims have been satisfied,

discounting FCFE by r (the required rate of return on
equity) gives the value of the firms equity.
Dividing the total value of equity by the number of
outstanding shares gives the value per share.

Single-stage, constant-growth
FCFE valuation model
FCFE

in any period will be equal to FCFE

in the preceding period times (1 + g):
FCFEt = FCFEt1 (1 + g).

The

value of equity if FCFE is growing at

a constant rate is
FCFE1 FCFE 0 (1 g )
Equity Value

rg
rg

The

discount rate is r, the required return

on equity. The growth rate of FCFF and
the growth rate of FCFE are frequently

Computing FCFF from Net

Income
This

equation can be written more

compactly as
FCFF = NI + Depreciation + Int(1 Tax rate)
Inv(FC) Inv(WC)

Or
FCFF = EBIT(1-tax rate) + depreciation Cap. Expend.
change in working capital change in other assets

Finding FCFE from NI or

CFO
Subtracting

after-tax interest and

adding back net borrowing from
the FCFF equations gives us the
FCFE from NI or CFO:

FCFE = NI + NCC Inv(FC)

Inv(WC)
+ Net borrowing
FCFE = CFO Inv(FC) + Net
borrowing

Forecasting free cash

flows
Computing

FCFF and FCFE based upon historical

accounting data is straightforward. Often times,
this data is then used directly in a single-stage DCF
valuation model.
On other occasions, the analyst desires to forecast
future FCFF or FCFE directly. In this case, the
analyst must forecast the individual components of
free cash flow. This section extends our previous
presentation on computing FCFF and FCFE to the
more complex task of forecasting FCFF and FCFE.
We present FCFF and FCFE valuation models in the
next section.

Forecasting free cash

flows
Given

that we have a variety of ways in which to

derive free cash flow on a historical basis, it should
come as no surprise that there are several methods
of forecasting free cash flow.
One approach is to compute historical free cash flow
and apply some constant growth rate. This approach
would be appropriate if free cash flow for the firm
tended to grow at a constant rate and if historical
relationships between free cash flow and
fundamental factors were expected to be
maintained.

Forecasting FCFE
If

the firm finances a fixed percentage of its capital

spending and investments in working capital with
debt, the calculation of FCFE is simplified. Let DR
be the debt ratio, debt as a percentage of assets.
In this case, FCFE can be written as

FCFE

= NI (1 DR)(Capital Spending Depreciation)

(1 DR)Inv(WC)

When

building FCFE valuation models, the logic,

that debt financing is used to finance a constant
fraction of investments, is very useful. This
equation is pretty common.

Preferred stock in the capital

structure
When

we are calculating FCFE starting with Net

income available to common, if Preferred
dividends were already subtracted when arriving
at Net income available to common, no further
adjustment for Preferred dividends is required.
However, issuing (redeeming) preferred stock
increases (decreases) the cash flow available to
common stockholders, so this term would be
added in.
In many respects, the existence of preferred stock
in the capital structure has many of the same
effects as the existence of debt, except that
preferred stock dividends paid are not tax
deductible unlike interest payments on debt.

Nonoperating assets and firm

value
When

calculating FCFF or FCFE, investments

in working capital do not include any
investments in cash and marketable
securities. The value of cash and marketable
securities should be added to the value of
the firms operating assets to find the total
firm value.
Some companies have substantial noncurrent investments in stocks and bonds that
are not operating subsidiaries but financial
investments. These should be reflected at
their current market value. Based on
accounting conventions, those securities
reported at book values should be revalued

Nonoperating assets and firm

value
Finally,

many corporations have

overfunded or underfunded
pension plans. The excess
pension fund assets should be
added to the value of the firms
operating assets. Likewise, an
underfunded pension plan should
result in an appropriate
subtraction from the value of
operating assets.