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C4.2. If cash is king, his subjects are not well served.

Look at the cash flows for General


Electric and Starbucks in Exhibit 4.2. Free cash flow does not incorporate accrual aspects of
value added. Free cash flow is reduced by investments, yet investment (typically) adds value.
Free cash flow is a liquidation concept, not a value-added concept.
E4.1. A Discounted Cash Flow Valuation
2012
Cash flow from operations
Cash investment
Free cash flow
Discount rate (1.10)t
PV of cash flows
Total PV to 2015
Continuing value*
PV of CV
a. Enterprise value
Net debt
b. Value of equity

* Continuing value =

2013

2014

2015

$1,450
$1,020
$ 430

1,576
1,124
452

1,718
1,200
518

1.21
374

1.331
389

1.10
391
$1,154

8,979
6,746
$7,900 million
759
$7,141 million

518 1.04

1.10 1.04

8,989

E4.2. A Simple DCF Valuation


F
V2012

430
1.10 1.05

= $8,600 million
E4.3. Valuation with Negative Free Cash Flows
Calculate free cash flow from the forecasts of cash flow from operations and cash investments.
Your will see that free cash flow is negative in all years except 2013:

2013
Cash flow from operations
Cash investments
Free cash flow

730
673
57

2014

2015

932
1,023
( 91)

1,234
1,352
( 118)

2016
1,592
1,745
( 153)

If you calculate the present value of these free cash flows (with any discount rate), youll get a
negative price. Prices cant be negative (with limited liability). The continuing value must be
greater than 100% of the price, but we have no way to calculate it. The free cash flows are
increasingly negative because, while cash flow from operations are positive and increasing, the
firm is investing more.
E4.4. Calculate Free Cash Flow from a Cash Flow Statement
Cash flow from operations reported
Interest payments
Interest receipts
Net interest payments
Tax at 35%
Cash flow from operations

$5,270
$1,342
876
466
163

303
5,573

Cash investments reported


$6,417
Purchase of short-term investments (4,761)
Sale of short-term investments
547
Free Cash Flow

2,203
3,370

E4.7. Calculating Cash Flow from Operations and Cash Investment for Coca-Cola
Cash flow from operations:
Reported cash flow from operations
Interest paid
$405
Interest received
236
Net interest paid
169
Tax deduction (at 36%)
61
Cash from operations

$7,150

108
$7,258 million

Cash investment:
Reported cash investment
Sale of investments
Purchase of investments

$6,719
$ 448
(99)

349

Cash investment in operations

$7,068

Cokes free cash flow was $7,258 7,068 = $190.


E4.8. Converting Forecasts of Free Cash Flow to a Valuation: Coco-Cola Company
This exercise demonstrates declining free cash flow on rising investment.
________________________________________________________________________
2004
2005
2006
2007
Cash flow from operations
Cash investments
Free cash flow

5,929
618
5,311

6,421
1,496
4,925

5,969
2,258
3,711

7,258
7,068
190

Though positive, the free cash flows are declining over the four years. If cash flows from
operations and cash investments were declining at about the same rate, we might conclude that
the firm indeed was in a state of decline: declining cash flows from the business lead to declining
investments. However, cash flows from operations are increasing and cash investment is
increasing at a faster rate: Coke is investing heavily. While free cash flow is declining over these
years, one would thus expect it to increase in future years as cash from the rising investment here
comes in. These cash flow are not a good indication of future free cash flows (and nor is the
$190 million of free cash flow in 2007 a good base to calculate a continuing value.)
If you were valuing Coke at the beginning of 2004 based on these subsequent cash flows, you
would have a big problem: you would have to forecast the cash flows after 2007 that the new
investment from 2005-2007 would produce. That is a difficult task, and it would extend the
forecast horizon to a point where outcomes are more uncertain.
The exercise is a good example of why free cash flow does not work, in principle: Investment
(which is made to generate cash flows actually decreases free cash flow, so rising investment
relative to cash flow from operations (lower free cash flow) typically means higher free cash
flow later.

E4.10. A Discounted Cash Flow Valuation: General Mills, Inc.


a. The exercise involves calculating free cash flows, discounting them to present value, then
adding the present value of a continuing value. For part (a) of the question, the continuing value
has no growth:
2005
Cash flow from operations
Cash investment in operations
Free cash flow (FCF)
Discount rate
Present value of FCF
Total of PV to 2009
5,419
Continuing value (CV)
PV of CV
12,885
Enterprise value
18,304
Net debt
6,192
Equity value
12,112

2006
2,014
300
1,714
1.09
1,572

2007
2,057
380
1,677
1.1881
1,411

2008
2009
2,095
2,107
442
470
1,653
1,637
1.2950
1.4116
1,276
1,160

Value per share on 369 million shares = $32.82

1,637
18,189
0.09

CV (no growth) =
18,189
12,885
1.4116
PV of CV =

b. With growth of 3% after 2009, the continuing value is:

CV

1,637 1.03
$28,102
1.09 1.03

The present value of the continuing value is $28,102/1.4116 = $19,908.


Do the valuation is as follows:
Total of PV to 2009
Continuing value (CV)
PV of CV
Enterprise value

5,419
28,102
19,908
25,327

18,189

Net debt
Equity value

6,192
19,135

Value per share on 369 million shares = $51.86.


E4.12. Cash Flows for Wal-Mart Stores
a. Wal-Mart is an expanding company with opportunities to invest in new stores throughout
the world. While it generates considerable cash flow from operations, cash investments
routinely exceed cash from operations. So free cash flow is negative. This is a firm like
General Electric in Exhibit 4.2. DCF analysis will not work for this firm.
b. The difference between earnings and cash from operations is due net interest (after-tax)
and accruals.
The difference between earnings and free cash flows is due to net interest (after
tax), accruals and investments in operations.
c. DCF will not work. Negative free cash flows yield negative values.