Free Cash Flow Valuation

Free cash flow to the firm (FCFF) is the cash

flow available to the firms suppliers of capital
after all operating expenses have been paid
and necessary investments in working capital
and fixed capital have been made.


Free cash flow to equity (FCFE) is the cash flow
available to the firms common equity holders
after all operating expenses, interest and
principal payments have been paid, and
necessary investments in working and fixed
capital have been made


Valuing FCFF
The FCFF valuation approach estimates the value of
the firm as the present value of future FCFF
discounted at the weighted average cost of capital
(WACC)

Discounting FCFF at the WACC gives the total value of
all of the firms capital. The value of equity is the value of
the firm minus the market value of the firms debt

Equity Value = Firm Value Market Value of Debt




Valuing FCFE
The value of equity can also be found by
discounting FCFE at the required rate of
return on equity (r):

Since FCFE is the cash flow remaining for
equity holders after all other claims have
been satisfied, discounting FCFE by r (the
required rate of return on equity) gives the
value of the firms equity
Calculating a WACC
The cost of capital is the required rate of return
that investors should demand for a cash flow
stream like that generated by the firm.

e d
r
equity MV debt MV
equity MV
rate Tax r
equity MV debt MV
debt MV
WACC
) ( ) (
) (
) 1 (
) ( ) (
) (

Valuing FCFE
The value of equity can also be found by
discounting FCFE at the required rate of return
on equity (r):

1
FCFE
Equity Value
(1 )
t
t
t
r

Dividing the total value of equity by the number of outstanding shares gives the
value per share.
Single-stage constant-growth
FCFF valuation model
FCFF in any period is equal to FCFF in the
previous period times (1 + g):
FCFF
t
= FCFF
t1
(1 + g).
The value of the firm if FCFF is growing at a
constant rate is


Subtracting the market value of debt from the
firm value gives the value of equity.

Single-stage, constant-growth
FCFE valuation model
FCFE in any period will be equal to FCFE in
the preceding period times (1 + g):
FCFE
t
= FCFE
t1
(1 + g).

The value of equity if FCFE is growing at a constant
rate is

0 1
FCFE (1 ) FCFE
Equity Value
g
r g r g

Computing FCFF from Net Income
FCFF = Net income available to common
shareholders
Plus: Net Non-Cash Charges
Plus: Interest Expense times (1
Tax rate)
Less: Investment in Fixed Capital
Less: Investment in Working capital
Computing FCFF from CFO



FCFF = Cash Flow from Operations
Plus: Interest Expense times (1
Tax rate)
Less: Investment in Fixed
Capital
The best place to find historical non-cash
charges is to review the firms statement of
cash flows.

Non-Cash Item Adjustment to NI to arrive at CF
Depreciation Added Back
Amortization of intangibles Added Back
Restructuring Charges (expense) Added Back
Restructuring Charges (income resulting
from reversal)
Subtracted
Losses Added Back
Gains Subtracted
Amortization of long-term bond discounts Added Back
Amortization of long-term bond premium Subtracted
Deferred taxes Warrants special attention

Finding FCFE from FCFF
Free cash flow to equity is cash flow available to
equity holders only. It is therefore necessary to
reduce FCFF by interest paid to debtholders and to
add any net increase in borrowing (subtract any net
decrease in borrowing).

FCFE = Free cash flow to the firm
Less: Interest Expense times (1 Tax rate)
Plus: Net Borrowing
Or
FCFE = FCFF Int(1 Tax rate) + Net borrowing

Finding FCFE from NI
Subtracting after-tax interest and adding
back net borrowing from the FCFF
equations gives us the FCFE from NI or
CFO:

FCFE = NI + NCC Inv(FC) Inv(WC)
+ Net borrowing
FCFE = CFO Inv(FC) + Net borrowing

Finding FCFF from EBIT

FCFF = EBIT (1 Tax rate) + Dep Inv(FC) -
Inv(WC)
Finding FCFF from EBITDA
FCFF = EBITDA(1 Tax rate) + Dep(Tax rate) -
Inv(FC) Inv(WC)

To get FCFF from EBITDA, multiply EBITDA times (1
Tax rate), add back depreciation times the tax rate, and then
subtract the investments in fixed capital and working capital

Forecasting FCFF
When forecasting FCFE, analysts often simplify
the estimation of FCFF and FCFE. Equation 3-7
can be restated as
FCFF = NI + Int (1 Tax rate)
(Capital spending Depreciation) Inv(WC)
which is equivalent to
FCFF = EBIT (1 Tax rate)
(Capital spending Depreciation) Inv(WC)

The components of FCFF in these equations are
often forecasted in relation to sales.


Forecasting FCFE
FCFE can be written as
FCFE = NI (1 DR)(Capital Spending
Depreciation)
(1 DR)Inv(WC)

When building FCFE valuation models, the
logic, that debt financing is used to finance
a constant fraction of investments, is very
useful. This equation is pretty common.

Two-stage FCF models
The two most popular versions of the two-
stage FCFF and FCFE models are:

the growth rate is constant (or given) in stage
one, and then it drops to the long-run
sustainable rate in stage two.
the growth rates are declining in stage one,
reaching the sustainable rate at the beginning
of stage two. This latter model is like the H
model for dividend valuation.


A general expression for the two-stage FCFF
valuation model is


1
1
FCFF FCFF 1
Firm Value= +
(WACC- ) (1+WACC) (1+WACC)
n
t n
t n
t
g

The general expression for the two-stage FCFE valuation model is

1
1
FCFE FCFE 1
Equity
(1 ) (1 )
n
t n
t n
t
r g r r

Proust Company (#5)

Proust Company has free cash flow to the firm of $1.7
billion and free cash flow to equity of $1.3 billion.
Prousts weighted average cost of capital is 11 percent
and its required rate of return for equity is 13 percent.
FCFF is expected to grow forever at 7 percent and FCFE
is expected to grow forever at 7.5 percent. Proust has
debt outstanding of $15 billion.

A. What is the total value of Prousts equity using the FCFF
valuation approach?
B. What is the total value of Prousts equity using the FCFE
valuation approach?

A. The Firm Value is the present value of FCFF discounted
at the weighted average cost of capital (WACC), or


The market value of equity is the value of the firm minus
the value of debt:
Equity = 45.475 15 = $30.475 billion.
B. Using the FCFE valuation approach, the present value of
FCFE, discounted at the required rate of return on
equity, is


The value of equity using this approach is $25.409 billion.