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Free cash flows to equity/firm

Chapter -4
free cash flows to equity/ frim 1
Learning Objectives
Introduction
Forecasting FCFE/FCFF
Equity of cost of capital

free cash flows to equity/ frim 2
Valuing the Firm
Economic theory teaches us that the value of an
investment is:
free cash flows to equity/ frim 3
Expected future payoffs can be measured in
terms of:
Dividends
Cash Flows
Earnings

=
+
=
n
t
t
t
V
1
0
Rate) Discount (1
Payoffs Future Projected
Approaches to firm valuation
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Focus is on the cash that flows into the firm.
Measures the cash flows that are free to be
distributed to shareholders.
Cash flows generated by the firm create
dividend-paying capacity.
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Cash-Flow-Based Valuation
Amount of cash flowing into firm differs from
dividends paid in a particular period.
But over the lifetime of the firm, cash flows
into and cash flows out of the firm will be
equal.
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Cash-Flow-Based Valuation (Contd.)
Cash is the ultimate source of value. The
free cash flows approach measures value
based on the cash flows that the firm
generates that can be distributed to
investors.
It is a measurable common denominator
for comparing the future benefits of
alternative investment instruments.
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Rationale for Using Free-Cash-Flows
Cost of Common Equity Capital
CAPM Model:
free cash flows to equity/ frim 8
portfolio marketwide on return Required
j firm for beta Market
return of rate free - Risk
j firm in equity common on return Required
n expectatio
: Where

=
=
=
=
=
+ =
M
j
F
Ej
F M j F Ej
R

R
R
E
]} ]E[R {E[R ] E[R ] E[R
Weighted Average Cost of Capital
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costs debt to applicable rate is rate Tax
capital of type each of proportion is w
capital of type each of cost is R
: Where
1
1
= + +
+ + =
E P D
E E P P D D A
w w w
] R [w ] R [w ] tax rate) ( R [w R
Measuring Free Cash Flows
Under U.S. GAAP and IFRS, Cash flow
statement categorize the activities as
operating, investing and financing.
Some rearrangements are necessary to
compute free cash flows.
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Measuring Free Cash Flows (Contd.)
Cash flow from operations from the
projected statement of cash flows is the most
direct starting point because it requires the
fewest adjustments.
However, some analysts compute free cash
flows using alternative starting points.
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Measuring Free Cash Flows
Free Cash Flows for All Debt and Equity Stakeholders:
Operating Activities:
Cash Flow from Operations
+/- Net Interest after Tax
+/- Changes in Cash Requirements for Liquidity
= Free Cash Flows from Operations for All Debt and Equity

Investing Activities:
+/- Net Capital Expenditures
= Free Cash Flows for All Debt and Equity Stakeholders
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Measuring Free Cash Flows
Free Cash Flows for Common Equity Shareholders:
Operating Activities:
Cash Flow from Operations
+/- Changes in Cash Requirements for Liquidity
= Free Cash Flows from Operations for Equity

Investing Activities:
+/- Net Capital Expenditures

Financing Activities:
+/- Debt Cash Flows
+/- Financial Asset Cash Flows
+/- Preferred Stock Cash Flows
= Free Cash Flows for Common Equity Stakeholders
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Cash-Flows-Based Valuation Models
To value common equity measure:
Discount rate R
E
.
Expected future free cash flows FCF
Eq
for
periods 1 through T over forecast horizon.
Continuing free cash flows, FCF
Eq(T+1)
, and long-
run growth rate, g.
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Free-Cash-Flows-Based Valuation Models
For common equity shareholders:
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rate Growth
capital equity on return of rate Required
rs shareholde equity common for flows cash Free
firm a of equity common the of value Present
Where,
=
=
=
=
+ +
(

+
=

=
+
g
R
FCFE
V
] ) R /( [ g)] /(R [ ] [FCFE
) R (
FCFE
V
E
T
t
T
E E T
t
E
t
0
1
1 0
1 1 1
1
Free-Cash-Flows-Based Valuation Models
For all debt and equity capital stakeholders:
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rate Growth
capital of cost average weighted future Expected
rs stakeholde
capital equity and debt all for flows cash Free
firm a of assets operating net of value Present
Where,
=
=
=
=
+ +
(

+
=

=
+
g
R
FCFA
VNOA
] ) R /( [ g)] /(R [ ] [FCFA
) R (
FCFA
VNOA
A
T
t
T
A A T
t
A
t
0
1
1 0
1 1 1
1
Continuing Value
Represented by last term of equation:


Use expected long-term growth rate, g, to
project all items on Year T+1 income
statement and balance sheet.
R
A
must be greater than g for this formula to
work.
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] ) R /( [ g)] /(R [ ] [FCFA
T
A A T
+
+
1 1 1
1
What now?
Once valuation model is applied, then
Conduct sensitivity analysis:
Vary cost of equity capital rate (R
E
)
Vary long-run growth rate (g)
Discount rate assumptions
Vary these parameters and assumptions
individually and jointly.
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Evaluation of the Free-Cash-Flows-Valuation method
Advantages:
Focuses on free cash flows, believed to
have more economic meaning than
earnings.
Results from projections of future
operating, investing, and financing
decisions of a firm made by the analyst.
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Evaluation of the Free-Cash-Flows-Valuation method
Advantages: (Contd.)
Focuses directly on net cash inflows
available to be distributed to capital
providers. This perspective is especially
pertinent to acquisition decisions.
Widely used in practice.
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Evaluation of the Free-Cash-Flows-Valuation method
Disadvantages:
Can be time-consuming making it costly.
Continuing value tends to dominate the total
value but is sensitive to assumptions growth
rates and discount rates.
Free cash flow computations must be
internally consistent with long-run
assumptions regarding growth and payout.
And is affected by estimation errors.
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Learning Outcomes
Measurement of cost of capital
Cost of debt
Security valuation
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