FREE CASH FLOW

ANALYSIS
Fransisca Tharia
Meeting 4 – updated 2020
Security Analysis

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M A T E RIAL IN P U BLIC D O M A IN. F O R P RIV A T E U SE O N LY.
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The Building Blocks of Valuation

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SH A RE T H IS M A T E RIAL IN P U BLIC D O M A IN. F O R P RIV A T E U SE O N LY.
 Free Cash Flow
Free Cash Flow to the Free Cash Flow to
Firm Equity

= Cash flow available

= Cash flow available to
to

Common stockholders Common stockholders

Debtholders

Preferred stockholders

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FCFF vs. FCFE Approaches to
Equity Valuation
Equity Value

FCFE Discounted FCFF Discounted

at Required at WACC – Debt
Equity Return Value

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FCFF vs. FCFE Approaches to
Equity Valuation
∞
FCFFt
Firm value = ∑
t =1 (1 + WACC )
t

=
Equity value Firm value − Debt value

∞
FCFEt
Equity value = ∑
t =1 (1 + r )
t

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Single-Stage Free Cash Flow Models
FCFF1
Firm value =
WACC − g
=
Equity value Firm value − Debt value

FCFE1
Equity value =
r−g

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Example: Single-Stage FCFF Model
Current FCFF $6,000,000
Target debt to capital 0.25
Market value of debt $30,000,000
Shares outstanding 2,900,000
Required return on equity 12.0%
Cost of debt 7.0%
Long-term growth in FCFF 5.0%
Tax rate 30%

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 Example: Single-Stage FCFF Model
 MV(Debt)    MV(Equity)  
=WACC  ×
 d r × (1 − Tax rate) +
  × r
 MV(Equity) + MV(Debt)    MV(Equity) + MV(Debt)  

=
WACC [0.25 × 7% × (1 − 0.30)] + [0.75 ×12%=] 10.23%

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 Example: Single-Stage FCFF Model
FCFF1
Firm value =
WACC − g
$6, 000, 000(1.05)
=
Firm value = $120.5 million
0.0123 − 0.05
Equity value= $120.5 million − $30 million= $90.5 million
Equity value per share= $90.5 million / 2.9 million= $31.21

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Using Net Income to Determine FCFF

FCFF =NI + NCC + Int (1 – Tax rate ) – FCInv – WCInv

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Other Noncash Adjustments
Amortization • Added back
Restructuring
Expense
• Added back
Restructuring
Income
• Subtracted out
Capital Gains • Subtracted out
Capital Losses • Added back
Employee Option
Exercise
• Added back
Deferred Taxes • Added back?
Tax Asset • Subtracted out?

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 Using EBIT and EBITDA to Determine
FCFF
=FCFF EBIT (1 – Tax rate ) + Dep – FCInv – WCInv

=FCFF EBITDA (1 – Tax rate ) + Dep ( Tax rate ) – FCInv – WCInv

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Using Cash Flow from Operations
to Determine FCFF

= CFO + Int (1 – Tax rate ) – FCInv

FCFF

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 Calculating FCFE from
FCFF, Net Income, & CFO
FCFE FCFF – Int (1 – Tax rate ) + Net borrowing

FCFE from net income (NI) and FCFF:

FCFF = NI + NCC + Int (1 – Tax rate ) – FCInv – WCInv
FCFE = NI + NCC – FCInv – WCInv + Net borrowing
FCFE from CFO and FCFF:
= CFO + Int (1 – Tax rate ) – FCInv
FCFF
=
FCFE CFO – FCInv + Net borrowing

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 FCFE & FCFF on a Uses of FCF Basis
Δ Cash balance + Net payments to debtholders + Net payments to stockholders,
FCFF =

=FCFE Δ Cash balance + Net payments to stockholders

to debtholders Int (1 – Tax rate ) + Debt repayments – Debt issuances

Where Net payments=

Where Net payments to=

stockholders Cash dividends + Share repurchases – Stock issuances

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 Example: Calculating FCFF
EBITDA $1,000
Depreciation expense $400
Interest expense $150
Tax rate 30%
Purchases of fixed assets $500
Change in working capital $50
Net borrowing $80
Common dividends $200

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Example: Calculating FCFF from Net
Income
NI = ( EBITDA – Dep – Int )(1 – Tax rate )

NI (=
$1000 – $400 – $150 )(1 – 0.30 ) $315

FCFF =NI + NCC + Int (1 – Tax rate ) – FCInv – WCInv

FCFF = $315 + $400 + $150 (1 – 0.30 ) – $500 – $50 = $270

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 Example: Calculating FCFF from
EBIT and EBITDA
= =
EBIT EBITDA =
– Dep $1000 – $400 $600

=FCFF EBIT (1 – Tax rate ) + Dep – FCInv – WCInv

$600 (1 – 0.30 ) + $400 – $500 – $50 =
FCFF = $270

=FCFF EBITDA (1 – Tax rate ) + Dep ( Tax rate ) – FCInv – WCInv

$1000 (1 – 0.30 ) + $400 ( 0.30 ) – $500 – $50 =
FCFF = $270

T H IS M A T E RIA LS BE L ONG T O U N IVE RSITA S P RA SE TIYA M U L YA . D O N O T

SH A RE T H IS M A T E RIAL IN P U BLIC D O M A IN. F O R P RIV A T E U SE O N LY.
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Example: Calculating FCFF from CFO
= NI + Dep – WCinv
CFO
CFO =+
$315 $400 – $50 =$665

= CFO + Int (1 – Tax rate ) – FCInv

FCFF
$665 + $150 (1 – 0.30 ) – $500 =
FCFF = $270

T H IS M A T E RIA LS BE L ONG T O U N IVE RSITA S P RA SE TIYA M U L YA . D O N O T

SH A RE T H IS M A T E RIAL IN P U BLIC D O M A IN. F O R P RIV A T E U SE O N LY.
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 Example: Calculating FCFE from
FCFF, Net Income, & CFO
FCFE FCFF – Int (1 – Tax rate ) + Net borrowing
=FCFE $270 – $150=(1 – 0.30 ) + $80 $245

FCFE = NI + NCC – FCInv – WCInv + Net borrowing

FCFE = $315 + $400 – $500 – $50 + $80 = $245

=
FCFE CFO – FCInv + Net borrowing
=
FCFE $665 – $500=
+ $80 $245

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Example: Calculating FCFE & FCFF
on a Uses Basis
Net payments to debtholders = Int (1 – Tax rate ) + Debt repayments − Debt issuances
= $150 (1 − 0.30 ) + $0 − $80
Net payments to debtholders = $25

Net payments to stockholders =Cash dividends + Share repurchases − Stock issuances

Net payments to stockholders= $200 + $0 − $0= $200

ΔCash Balance = CFO ± Cash from investing activities ± Cash from financing activities
ΔCash Balance = $665 − $500 + $80 − $200 = $45

FCFF = $45 + $25 + $200 = $270

FCFE = $45 + $200 = $245

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 Forecasting FCFF & FCFE
FCFF =EBIT(1 − Tax rate) − ΔCapital expenditures − ΔWCInv

FCFE = NI − (1 − DR )( FCInv − Dep ) − (1 − DR )( WCInv )

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Example: Forecasting FCFF & FCFE
Sales $4,000
Sales growth $200
EBIT $600
Tax rate 30%
Purchases of fixed assets $800
Depreciation expense $700
Change in working capital $50
Net income margin 10%
Debt ratio 40%

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Example: Forecasting FCFF & FCFE
=
Sales = 5%
growth $200/$4000
=
EBIT =
margin $600 / $4000 15%

( $800 − $700 )
=
Incremental FC/Sales growth = 50%
$200
$50
= = 25%
Incremental WC/Sales growth
$200

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 Example: Forecasting FCFF
Sales =$200 + $4000 =$4200

= =
EBIT $4200 × 15% $630
EBIT(1 − Τ=
ax rate) $630 × (1=
− 30%) $441
Incremental FC = $200 × 50% = $100

Incremental WC = $200 × 25% = $50

FCFF =EBIT(1 − Tax rate) − ΔCapital expenditures − ΔWCInv

FCFF = $441 − $100 − $50 = $291

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Example: Forecasting FCFE
Sales =$200 + $4000 =$4200

Net income = $4200 × 10% = $420

Incremental FC = $200 × 50% = $100

Incremental WC = $200 × 25% = $50

FCFE = NI − (1 − DR )( FCInv − Dep ) − (1 − DR )( WCInv )

= $420 − (1 − 0.40 )( $100 ) − (1 − 0.40 )( $50=

FCFE ) $330

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Three Stage Model FCF

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Three Stage Model FCF

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When Should We Use Three Stage
Model
• Since the model allows for three stages of growth, and for a
gradual decline from high to stable growth, it is the
appropriate model to use to value firms with very high
growth rates currently. The assumptions about growth are
similar to the ones made by the three-stage dividend
discount model, but the focus is on FCFE instead of
dividends, making it more suited to value firms whose
dividends are significantly higher or lower than the FCFE.

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Example of Three Stage Model
Equity Cost of Present
Year Expected Growth Net Income Reinvestment Rate FCFE Equity Value
Current CY72.36 149.97%
1 44.91% CY104.85 149.97% (CY52.40) 14.71% (CY45.68)
2 44.91% CY151.93 149.97% (CY75.92) 14.71% (CY57.70)

3 44.91% CY220.16 149.97% (CY110.02) 14.71% (CY72.89)

4 44.91% CY319.03 149.97% (CY159.43) 14.71% (CY92.08)

5 44.91% CY462.29 149.97% (CY231.02) 14.71% (CY116.32)

6 37.93% CY637.61 129.98% (CY191.14) 14.56% (CY84.01)

7 30.94% CY834.92 109.98% (CY83.35) 14.41% (CY32.02)
8 23.96% CY1,034.98 89.99% CY103.61 14.26% CY34.83
9 16.98% CY1,210.74 69.99% CY363.29 14.11% CY107.04
10 10.00% CY1,331.81 50.00% CY665.91 13.96% CY172.16

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 Issues in FCF Analysis
Financial Statement Discrepancies

Dividends vs. FCFE

Effect of Shareholder Cash Flows & Leverage

FCFF & FCFE vs. EBITDA & Net Income

Country Adjustments

Sensitivity Analysis

Nonoperating Assets
T H IS M A T E RIA LS BE L ONG T O U N IVE RSITA S P RA SE TIYA M U L YA . D O N O T
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