FREE CASH FLOW VS.

CASH FLOWS TO SHAREHOLDERS

DATA Cost of debt Tax rate Cost of equity 10% 40% 12% EBIT Investment Amount borrowed 6.00 12.00 4.00

CASH FLOWS TO SHAREHOLDERS Year EBIT Less interest Earnings before taxes Taxes Net income Investment by shareholders Net cash flow to shareholders NPV at cost of equity Market value of equity 0 1 6.00 (0.40) 5.60 (2.24) 3.36 3.36 2 6.00 (0.40) 5.60 (2.24) 3.36 3.36 3 6.00 (0.40) 5.60 (2.24) 3.36 3.36 Goes on forever

(8.00) (8.00) 20.00 28.00

WEIGHTED AVERAGE COST OF CAPITAL Proportion of Market Value 12.5% 87.5% Weighted Cost of Capital 0.8% 10.5% 11.3%

Cost of Capital Debt (after-tax) Equity Weighted average cost of capital 6.0% 12.0%

FREE CASH FLOW Year EBIT Taxes EBIAT Investment Free cash flow NPV at WACC 0 1 6.00 (2.40) 3.60 3.60 2 6.00 (2.40) 3.60 3.60 3 6.00 (2.40) 3.60 3.60 Goes on forever

(12.00) (12.00) 20.00

AFTER-TAX CASH FLOWS FROM LENDERS Year Interest Interest tax shield After-tax interest Principal receipt (repayment) Principal plus after-tax interest NPV at after-tax cost of debt 0 1 (0.40) 0.16 (0.24) (0.24) 2 (0.40) 0.16 (0.24) (0.24) 3 (0.40) 0.16 (0.24) (0.24) Goes on forever

4.00 4.00 -

CONCLUSION Cash flows to shareholders After-tax cash flows to lenders Free cash flow (8.00) (4.00) (12.00) 3.36 0.24 3.60 3.36 0.24 3.60 discount at cost of equity discount at after-tax cost of debt discount at WACC

NPV of cash flows to shareholders = NPV of free cash flows + NPV of after-tax cash flows from lenders

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FREE CASH FLOW VS. CASH FLOWS TO SHAREHOLDERS

DATA
Cost of debt Tax rate After-tax cost of debt Cost of equity 10% 40% 6% 12% EBIT Investment Amount borrowed Subsidized interest rate Market value of debt 6.00 12.00 4.00 5% 2.00

CASH FLOWS TO SHAREHOLDERS

Year EBIT Less interest Earnings before taxes Taxes Net income Investment by shareholders Net cash flow to shareholders NPV at cost of equity Market value of equity 0 1 6.00 (0.20) 5.80 (2.32) 3.48 3.48 2 6.00 (0.20) 5.80 (2.32) 3.48 3.48 3 6.00 (0.20) 5.80 (2.32) 3.48 3.48 Goes on forever

(8.00) (8.00) 21.00 29.00

WEIGHTED AVERAGE COST OF CAPITAL

Proportion of Market Value 6.5% 93.5% Weighted Cost of Capital 0.4% 11.2% 11.6%

Cost of Capital Debt (after-tax) Equity Weighted average cost of capital 6.0% 12.0%

FREE CASH FLOW

Year EBIT Taxes EBIAT Investment Free cash flow NPV at WACC 0 1 6.00 (2.40) 3.60 3.60 2 6.00 (2.40) 3.60 3.60 3 6.00 (2.40) 3.60 3.60 Goes on forever

(12.00) (12.00) 19.00

AFTER-TAX CASH FLOWS FROM LENDERS

Year Interest Interest tax shield After-tax interest Principal receipt (repayment) Principal plus after-tax interest NPV at after-tax cost of debt 0 1 (0.20) 0.08 (0.12) (0.12) 2 (0.20) 0.08 (0.12) (0.12) 3 (0.20) 0.08 (0.12) (0.12) Goes on forever

4.00 4.00 2.00

CONCLUSION
Free cash flow After-tax cash flows from lenders Cash flows to shareholders (12.00) 4.00 (8.00) 3.60 (0.12) 3.48 3.60 (0.12) 3.48 discount at WACC discount at after-tax ordinary cost of debt discount at cost of equity

NPV of cash flows to shareholders = NPV of free cash flows + NPV of after-tax cash flows from lenders

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FREE CASH FLOW VS. CASH FLOWS TO SHAREHOLDERS

We seldom encounter perpetuities. This shows how to calculate the PV of after-tax cash flows from bonds when the subsidized loan is a bullet loan (principal repaid only at maturity).

DATA

Cost of debt Tax rate After-tax cost of debt

10% 40% 6%

Amount borrowed Subsidized rate

4.00 5%

AFTER-TAX CASH FLOWS FROM BONDS

Year Interest Interest tax shield After-tax interest Principal receipt (repayment) Principal plus after-tax interest PV factor at after-tax cost of debt PV of cash flow Cumulative PV NPV

1 (0.20) 0.08 (0.12) (0.12) 94% (0.11) 3.89

2 (0.20) 0.08 (0.12) (0.12) 89% (0.11) 3.78

3 (0.20) 0.08 (0.12) (0.12) 84% (0.10) 3.68

4 (0.20) 0.08 (0.12) (4.00) (4.12) 79% (3.26) 0.42

4.00 4.00 100% 4.00 4.00 0.42

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