Business Financing and Planning - Free Cash Flow to Firm (FCFF) and EVA Valuation

Free Cash Flow to Firm (FCFF) Valuation

Enter the information highlighted in yellow.

This is a Three-stage FCFF Valuation Model, also presented in terms of projected EVA.

Current Inputs

Enter the current revenues of the firm =

Enter current capital invested in the firm =

{ As a na�ve estimate, you can use BV of debt + BV of Equity)

Enter the current depreciation =

Enter the current capital expenditures for the firm =

Enter the change in Working Capital in last year =

Enter the value of current debt outstanding =

Enter the number of shares outstanding =

High Growth Period

Enter the growth rate in revenues for the next 5 years =

What will COGS be as a % of revenues in the fifth year?

(COGS includes depreciation: This is equal to (1-Pre-tax Operating Margin))

How much debt do you plan to use in financing investments?

Enter the growth rate in capital expenditures & depreciation

Enter working capital as a percent of revenues

Enter the tax rate that you have on corporate income

What beta do you want to use to calculate cost of equity =

Enter the current long term bond rate =

Enter the market risk premium you want to use =

Enter your cost of borrowing money =

Stable Period

Enter the growth rate in revenues =

Enter COGS as a % of revenues in stable period =

Enter capital expenditures as a percent of depreciation in this period

How much debt do you plan to use in financing investments?

Enter interest rate of debt in stable period =

What beta do you want to use in the stable period =

ESTIMATED CASHFLOWS

Base

Growth in Revenue

Growth in Deprec'n

Revenues

COGS

% of Revenues

- $ COGS

EBIT

Tax Rate

EBIT (1-t)

+ Depreciation

- Capital Expenditures

- Change in WC

= FCFF

Terminal Value

COSTS OF EQUITY AND CAPITAL

Cost of Equity

Proportion of Equity

After-tax Cost of Debt

Proportion of Debt

Cost of Capital

Cumulative WACC

Present Value

FIRM VALUATION:

Value of Firm

- Value of Debt

Value of Equity

Value of Equity per Share

Value of Firm by year

$ Value of Debt

EVA Valuation

Terminal Year

- WACC (CI)

EVA

Terminal EVA

PV of EVA

+ Capital Invested

+ PV of Chg Capital in Yr 10

This reconciles the assumptions on stable growth, ROC and Capital Invested

= Firm Value

WACC

ROC

Capital Invested
(Adjusted to reflect terminal ROC)

Calculation of Capital Invested

Initial

+ Net Cap Ex

+ Chg in WC

Ending

Cumulated WACC

Automatic recalculation

Valuation Tutorial:
Free Cash Flow and Residual Income Analysis and Calculations

Compare Discounted Dividend, Free Cash Flow and Residual Income Valuation Models

Dividends: the cash flow that non-controlling shareholders receive.

Free Cash Flow: the cash flow that controlling shareholders could receive.

Residual Income: Measures ‘economic profits’ after the cost of capital is subtracted.

Determine the circumstances when a dividend discount model (DDM) is appropriate for valuing a stock:

Dividend Discount Model (DDM) is appropriate when

The company is currently paying dividends or a solid estimate of future dividends can be estimated.

Firm has known dividend policy that is consistent with profitability.

Investor takes a non-control perspective.

Free Cash Flow (FCF) model is appropriate:

the company is not paying dividends, or the company is paying dividends, but they are not in line with earnings.

Free Cash Flow aligns with company’s profitability

Investor takes a control perspective

Residual Income (RI) is the appropriate model:

Company is not paying a dividend, the RI model can be used as an alternative to FCF models.

When the expected FCF are negative over the forecast horizon (company that is growing rapidly and needs a lot capital investment).

'EVA' is a Residual Income Model

Free Cash Flow to the Firm (FCFF):

The Cash Flow available to the suppliers of capital (debt & equity) after paying all operating expenses and necessary investments in working capital and long term assets have been covered.

Free Cash Flow to Equity (FCFE):

The Cash Flow available to the common shareholders after paying all operating expenses, interest expense, necessary investments in working capital and long term assets have been covered and adjusted for net changes in long term debt.

Free Cash Flow Valuation

Define and interpret free cash flow to the firm (FCFF) and free cash flow to equity (FCFE):

To calculate PV of FCFF and FCFE:

For FCFF use Weighted Average Cost of Capital

For FCFE use the Cost of Equity

If you use WACC with FCFE, you will overstate the value of the equity

If you use Cost of Equity with FCFF, you will understate the value of the firm

Describe the FCFF and FCFE approaches to valuation and contrast the appropriate discount rates for each model:

Matching Cash Flows to Discount Rates

	Use WACC	Use K_eq
F.C.F.Firm	Correct Valuation	Valuation too low
F.C.F.Equity	Valuation too high	Correct Valuation

Note: WACC < Keq

Strengths and limitations of the FCFE model:

Strengths:

Can be used for non-dividend paying stocks
Can be used when dividends are inconsistent with firm’s ability to pay dividends

Limitations:

requires a ‘control perspective’
FCFE may be negative
Difficult to use if capital structure changes

Contrast the ownership perspective implicit in the FCFE approach to the ownership perspective implicit in the dividend discount approach:

FCFE approach assumes a control perspective so that the FCFE is available for use, while

The DDM assume a non-control position where the cash flow is only from the dividends.

However, keep in mind that if a firm’s dividends are less than FCFE, then the firm is investing the difference and that should affect the value of the stock.

Discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), or cash flow from operations (CFO) to arrive at FCFF and FCFE:

FCFF = EBIT × (1 - t) plus 3 Adjustments

= EBIT × (1 – t) + 3Adjustments
= NI + [Int.Exp. × (1 – t)] + 3Adjustments
= (EBITDA – Depr) × (1 – t) + 3Adjustments
= CFO⁽³⁾ + Int.Exp. × (1 – t) – New Fixed Assets

Note:

EBIT × (1 – t) = NI + [Interest Expense × (1 – t)] = (EBITDA – Depr) × (1 – t)

3Adjustments = Depr.⁽¹⁾ – New Fixed Assets⁽²⁾ – ∆NWC⁽²⁾

t = tax rate

⁽¹⁾ Depreciation is the main non-cash charge

⁽²⁾ New Fixed Assets & ∆ NWC: subtract increases, add decreases.

⁽³⁾ CFO = NI + Depr. – ∆ NWC

FCFE = NI + 3 Adjustments + borrowing

= FCFF – Int (1- t) + Net Borrowing
= NI + 3Adjustments + Net Borrowing
= (EBIT – Int.Exp.) × (1- t) + 3Adjustments + Net Borrowing
= (EBITDA – Int.Exp. – Depr.) × (1- t) + 3Adjustments + Net Borrowing
= CFO – New Fixed Assets + Net Borrowing

Note:

NI = (EBIT – Int.Exp.) × (1- t) = (EBITDA – Int.Exp. – Depr.) × (1- t)

t = tax rate

EBT = (EBIT – Int.Exp.) = (EBITDA – Int.Exp. – Depr.)

Contrast the recognition of value in the FCFE model to the recognition of value in dividend discount models:

FCFE recognizes value as the cash flow available to the shareholders and

the DDM recognizes value as the dividends paid to the shareholders.

If the FCFE is significantly different than the Dividends paid, then either
- the firm is retaining profits, such as Microsoft, or
- is paying out more than can be sustained over the long run.

Describe the characteristics of companies for which the FCFF model is preferred to the FCFE model.

When is FCFF preferred over FCFE?

If a firm currently has expected negative FCFE for several years in the future or

Has an unstable future capital structure, then

The FCFF model could be better than the FCFE model for valuing the firm.

Subtract debt from the value of the firm to get the value of the equity.

FCFF Example:

EBITDA	11,500
Depreciation	- 1,500	Net Borrowing	800
EBIT	10,000
Interest	- 1,000	Depreciation	1,500
EBT	9,000	New Fixed Assets	- 1,800
Tax (30%)	- 2,700	Change in NWC	- 900
Net Income	6,300	3 Adjustments	- 1,200

FCFF = EBIT × (1 - t) plus 3 adjustments

= EBIT × (1 – t) + 3 adjustments
= 10,000 × (0.7) + (-1,200) = 5,800
= NI + [Int.Exp. × (1 – t)] + 3ADJ
= 6,300 + [1,000 × 0.7] + (-1,200) = 5,800
= (EBITDA – Depr) × (1 – t) + 3ADJ
= (11,500 - 1,500) × 0.7 + (-1,200) = 5,800

FCFE Example:

EBITDA	11,500
Depreciation	- 1,500	Net Borrowing	800
EBIT	10,000
Interest	- 1,000	Depreciation	1,500
EBT	9,000	New Fixed Assets	- 1,800
Tax (30%)	- 2,700	Change in NWC	- 900
Net Income	6,300	3 Adjustments	- 1,200

FCFE = FCFF – [Interest x (1- t)] + Net Borrowing

= 5,800 - [1,000 × 0.7] + 800 = 5,900
= NI + 3Adjustments + Net Borrowing
= 6,300 + (-1,200) + 800 = 5,900
= (EBIT – Int.Exp.) × (1- t) + 3ADJ + Net Borrowing
= (10,000 - 1,000) × 0.7 + (-1,200) + 800 = 5,900
= (EBITDA – Int.Exp. – Depr.) × (1- t) + 3Adjustments + Net Borrowing
= (11,500 - 1,000 - 1,500) × 0.7 + (-1,200) + 800 = 5,900

Once we calculate the FCFF or FCFE, we would determine the appropriate discount rate and growth rate and calculate the Value of the Firm (PV of FCFF) or the Value of the Equity (PV of FCFE)

If we calculate the Value of the Firm, we would subtract the Value of the outstanding Debt to get the Value of the Equity.

Residual Income Valuation

A basic concept from Economics is that in order to make an ‘Economic Profit’ you must earn more than the cost of capital.

If you just earn the cost of capital or less, you did NOT make an economic profit.

If you only make a $2,000 profit on a $1,000,000 investment, you are really losing money since a 5% return in the bank would be $50,000!

Residual Income Definition and Calculation

Accounting reports show the ‘profit’ a company makes without a charge for the cost of the shareholders’ capital.

‘Residual Income’ subtracts the cost of capital to determine if there is any ‘economic income.’

Residual Income to Equity:
RI_Eq= NI – [Equity Capital x Cost of Eq Cap.]
Residual Income to the Firm:
RI_F= EBIT(1-t) - [Total Capital x WACC]

Economic Value Added (EVA)

From Stern Stewart & Company, an alternate measure of residual earnings

Looks at Residual Income for the Firm (NOT Common Stock) after SS&C adjustments.

EVA = NOPAT – Capital x WACC

NOPAT = EBIT + Adjustments – cash taxes

Capital = Total Assets – CL + Adjustments

WACC = Weighted Average Cost of Capital

EVA Adjustments

CGS and Inventory adjusted from LIFO to FIFO

Operating Leases are treated as capital leases

R&D is capitalized and then amortized over several years rather than expensed

Strategic investments that won�t generate revenue are backed out of capital

Any Goodwill Amortization is added back to capital and net income

Deferred taxes eliminated, only cash taxes

Residual Income Example
(simple method)

CA	15,000	CL	5,000	Total Cap.
Net FA	30,000	LTD	10,000	40,000
		Common Eq.	30,000	40,000
Total Assets	45,000	Total L&E	45,000

EBIT	10,000
Interest	- 1,000	WACC	10%
EBT	9,000	k_equity	12%
Tax (30%)	- 2,700
Net Income	6,300

RI_Eq = NI - (Eq × k_eq)

= 6,300 - (30,000 × 0.12) = 2,700

RI_F = EBIT(1-t) - [Total Capital × WACC]

= 10,000(0.7) - (40,000 × 0.10) = 3,000

Market Value Added (MVA)

MVA = Market Value of Company minus Book Value of Company

Book Value of Company = total capital

Also from Stern Stewart

MVA Example

CA	15,000	CL	5,000	Total Cap.
Net FA	30,000	LTD	10,000	40,000
		Common Eq.	30,000	40,000
Total Assets	45,000	Total L&E	45,000

Assume the firm has 10,000 shares of stock outstanding with a market price of $5.20 per share.

The MV of firm’s bonds is $11,000

MVA = MV_D+ MV_Eq- Total Capital

= $11,000 + (10,000 � $5.20) - $40,000

= $23,000

MVA measures if the firm has ‘created value’ for the shareholders.

MVA may be positive due to

acquiring positive NPV projects,

increases in the value of assets due to inflation,

minimizing the WACC,

issuing lots of debt BEFORE interest rates increase and/or

expectations of growth in income in the future

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