Free Cash Flow (FCF)

and
The Modigliani-Miller Propositions
 Predicting the cash flows
Cash operating
- expense
Interest payments
(excluding
interest expense)
- Fixed Capital
needs
- to creditors

Revenue
FCFF FCFE
(cash)

- Working
needs
Capital
+ Net borrowings
from Debt
holders
 Predicting the cash flow (contd…)
Calculating FCFF – 4 methods

All methods say the same thing, just in different dialects

FCFF = Net Income + Non Cash Expenses + Interest * (1-tax rate) – Capex – Working Capital Inv.

FCFF = CFO + Interest * (1-tax rate) – Capex

FCFF = EBITDA * (1-tax rate) + Non Cash Expenses * tax rate – Capex – Working Capital Inv.

FCFF = EBIT * (1- tax rate) + Non Cash Expenses – Capex – Working Capital Inv.

Just remember 1 Formula for FCFE

FCFE = FCFF – Interest * (1- tax rate) + net borrowings

 Computing FCFF
• Free Cash Flow to Firm (FCFF) is the cash flow that is generated by company’s operations and available to all the company’s
capital providers (investors), including both debt and equity

• Start with EBIT

Less: Taxes on EBIT
Plus or minus: change in deferred taxes
= NOPLAT (Net Operating Profits less adjusted taxes)
Add: Depreciation and Amortization
Plus or minus: Change in Working Capital
Less: Capital Expenditure
= Operating Free Cash Flow
Plus or minus: Cash flow from Non Operating Investments
= Cash Flow available to investors (FCFF)

• NOTE : FCFF does not include any of the financing related cash flows such as interest expense or dividends

n
FCFFt
PVFCFF  
t 1 (1  WACC ) t
5
 M&M Propositions
• Developed by economists Franco Modigliani and Merton Miller in 1958.
• Their main conclusions can be summarized as:
- In the absence of taxes, firm capital structure is irrelevant.
- With taxes, a firm's cost of capital can be lowered through issuing debt. This highlights the importance of debt as a tax shield.

• M&M Proposition I:
- Based on assumptions like there are No taxes
- No transaction cost.
- Both individuals and corporations can borrow at the same rate.
- Markets are perfectly efficient

• M&M Proposition II:

- The cost of debt is generally less than the cost of equity. That is if a firm pays a 5% yield on its debt, it will have to earn, say, 9% on
its equity. So it is assumed firms should borrow to take advantage of the cheaper rate.

- The increase in leverage level induces higher default probability to a company. Therefore, investors tend to demand a higher cost of
equity (return) to be compensated for additional risk. 6
 M&M Propositions (No Taxes)
• M&M Proposition I:
Value of unlevered firm (VU) = Value of levered firm (VL)
- The first proposition essentially claims that the company’s capital structure does not impact its value and is
irrelevant.
- A firm’s WACC is the same no matter what mix of debt and equity is used.

• M&M Proposition II:

re = ru + (ru - rd) D / E
re = WACC + (WACC - rd) D / E
rd = cost of debt
re = cost of levered equity
ru = cost of capital for all-equity firms i.e. cost of unlevered equity = WACC = return of firm’s assets
D / E = Debt Equity ratio

- The cost of equity rises as the firm increases its use of debt financing. As leverage increases, the expected return on
equity grows because equity becomes riskier.

- Changing leverage does change the return, but not the firm value. It also does not change the WACC

- Equity risk depends on the risk of firm operations (business risk) and the degree of financial leverage (financial risk).
7
 M&M Propositions (With Taxes)
• M&M Proposition I:
VL = VU + Tc * D
- Debt financing is highly advantageous and the value of a levered company is higher
than the value of an unlevered company .
- A firm’s WACC decreases as the firm relies more heavily on debt.

• M&M Proposition II:

re = ru + (1- Tc)(ru - rd) D / E
rd = cost of debt
re = cost of levered equity
ru = cost of capital for all-equity firms i.e. cost of unlevered equity = WACC = return of
firm’s assets
D = value of debt
E = value of stock or equity.
8
 M&M Propositions (With Taxes)
• M&M Proposition II:
re = ru + (1- Tc)(ru - rd) D / E

re = WACC+ (1- Tc)(WACC - rd) D / E

- All other variables are the same as in Proposition 2 of Theory 1 except for the factor of
(1 − t) which represents the tax shield i.e. the decrease in effective cost of debt due to
existence of tax benefit of debt.

- The implication of M&M theory with tax is that the capital structure is no longer irrelevant.
The value of a company with debt is higher than the value of a company with no or lower
debt. In the presence of taxes, the WACC decreases as we add leverage because of
additional tax shields.
- Cost of equity has two parts:
- ru and “business” risk
- D/E and “financial” risk
9
Example:

Q. A company is considering a business in which the expected WACC is 10%

keeping in view the associated business risk. It has option to incorporate in
Country A which has no taxes or in Country B which as 20% corporate taxes.

If the company’s cost of debt is 6% in both countries, find out its cost of equity in
both countries at the following debt-to-equity ratio levels: (a) zero, (b) 1, and
(c) 2.

10
n1

Example:
Country A: Country A has no taxes, so we can use the cost of equity function as in Proposition 2 of the Theory 1:

re @ D/E of 0 = 10% + (10% − 6%) × 0 = 10%

re @ D/E of 1 = 10% + (10% − 6%) × 1 = 14%
re @ D/E of 2 = 10% + (10% − 6%) × 2 = 18%

The weighted average cost of capital at all level of debt-to-equity ratio is the same i.e. 10%. Let’s see what happens at
D/E of 1 or D/V of 50%:

WACC = 50% × 6% + 50% × 14% = 10%

Country B: Existence of taxes creates a preference for debt resulting in a lower increase in equity with addition of
debt as demonstrated below:

re @ D/E of 0 = 10% + (10% − 6%) × (1 − 20%) × 0 = 10%

re @ D/E of 1 = 10% + (10% − 6%) × (1 − 20%) × 0 = 13.2%
re @ D/E of 2 = 10% + (10% − 6%) × (1 − 20%) × 2 = 16.2%

With increase in cost of equity is the WACC decrease with increase in debt-to-equity ratio. Theoretically, the value is
maximized for an all-debt company. However, the existence of some other factors such as probability of bankruptcy,
etc. causes the cost of debt to increase such that the value of a company is maximized at some intermediate point
(i.e. between an all-debt and an all-equity capital structure). 11
Slide 11

n1 namarta.singhal@gmail.com, 08-05-2019
Problem: Cost of Capital

Q. Alpha, Inc. has equity with a market value of $20 million and debt with a
market value of $10 million. Treasury bills that mature in one year yield 8% per
year, and the expected return on the market portfolio over the next year is 18%.
The beta of Acetate’s equity is .90. The firm pays no taxes. Answer the following
questions.

a. What is Alpha’s debt to equity ratio?

b. What is Alpha’s weighted average cost of capital?
c. What is the cost of capital for an otherwise identical all-equity firm?

12
 Problem Solution: Cost of Capital
a. What is Alpha’s debt to equity ratio?
Debt / Equity = $10 million/$ 20 million = .50

a. What is Alpha’s weighted average cost of capital?

First, we need to calculate the cost of equity.
Re = Rf + β [Rm - Rf] = .08 + .90 [.18 - .08] = .17 or 17%

*Remember one of the MM assumptions is that the firm’s debt is risk-free, so use the Treasury bill rate as the cost of
debt for the company.
In the absence of taxes, a firm’s weighted average cost of capital is equal to:
WAAC = [D/[D+E]]Rd + [E/[D + E]]Re
WAAC = [$10 million/$30 million](.08) + [$20 million/$30 million](.17)
WAAC = .14 or 14%

a. What is the cost of capital for an otherwise identical all-equity firm?

According to MM Proposition 2 with no taxes:
Re= RUL + [D/E] [RUL – Rd]
.17 = RUL + [.5] [RUL – .08]  RUL = .14 or 14%
This result is consistent with MM’s proposition that, in the absence of taxes, the cost of capital for an all-equity firm is
equal to the weighted average cost of capital for an otherwise identical levered firm. 13