1 Free Cash Flow Valuation: Some practical examples

FCFF and FCFE Valuation Approaches 2 Free cash flow to the firm is the cash flow available to the company’s suppliers of capital after all operating expenses (including taxes) have been paid and necessary investments in working capital and fixed capital have been made. Free cash flow to equity is the cash flow available to the company’s holders of common equity after all operating expenses (including taxes) have been paid and investments in working capital and fixed capital have been made.

Present Value of FCF 3 PV of FCFF is the future FCFF discounted at the WACC. PV of FCFE is the future FCFE discounted at the required rate of return on equity “r”. Dividing the total value of equity by the number of outstanding shares gives the value per share.

Constant Growth FCFF & FCFE Models 4 If FCFF grows at a constant rate, If FCFE grows at a constant rate,

5 The Weighted Average Cost of Capital (WACC) WACC = wd*rd (1-T) + we*re Where, Wd: weight of debt in the capital structure rd: cost of debt T: tax rate we: weight of equity in the capital structure re: return on equity

6 Example 3.1: A Swiss company has FCFF of 700 million Swiss francs (CHF) and FCFE of CHF620 million. The Company’s before- tax cost of debt is 5.7 percent, and its required rate of return for equity is 11.8 percent. The company expects a target capital structure consisting of 20 percent debt financing and 80 percent equity financing. The tax rate is percent, and FCFF is expected to grow forever at 5.0 percent. It has debt outstanding with a market value of CHF2.2 billion and has 200 million outstanding common shares.

7  What is the company’s weighted average cost of capital? WACC = 0.20(5.7%)( ) (11.8%) = 10.2%  What is the value of the comapny using the FCFF valuation approach? Firm Value = FCFF (1+g) / WACC – g = 700(1.05) / = 14,134.6 million  What is the value of the company’s equity using the FCFE valuation approach?

Computing FCFF 8 FCFF = NI + NCC + Int.(1-T) – FC Inv. – WC Inv. Where, NI : Net income NCC: Net noncash charges such as depreciation and amortization. Int.(1-T) : Interest expense (1 – Tax rate). It must be added because interest is a cash flow available to one of the company ’ s capital providers (i.e., the company ’ s creditors) FC Inv. : Investment in fixed capital, measured by the increase in FC WC Inv: Investment in working capital, measured by the increase in WC

9 EXAMPLE 4.1: Cane Distribution, Inc., incorporated on 31 December 2007 with initial capital infusions of $224,000 of debt and $336,000 of common stock, acts as a distributor of industrial goods. The following provide Cane’s financial statements for the three years following incorporation. Calculate Cane’s FCFF for each year.

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