Transcript Document 7735128

Chapters 7 & 11
Corporate Valuation Based
on Free Cash Flows (FCF)
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Corp. Valuation Based on Free
Cash Flows (FCF)

The Free Cash Flow Valuation model
can be applied to a firm that does not
pay dividends, a privately held firm, or
to a division of a firm.
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What is free cash flow (FCF) &
why is it important?


FCF is the cash from operations
available for distribution to investors
(stockholders and debtholders) after
making the necessary investments to
support operations.
A company’s value depends upon the
amount of FCF it can generate.
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Free Cash Flow Valuation


The FCF approach estimates total
enterprise value, rather than the value
of equity or per share value directly.
The value of equity (& per share value)
can be obtained from the total value by
netting out other claims.
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FCF Valuation

To use the FCF model, we must:
 Distinguish between operating assets
and nonoperating assets
 Calculate FCF
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Operating Assets

Operating assets:

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
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Tangible, necessary to operate the
business
Usually expected to grow
Generate free cash flows
The PV of expected future free cash
flows, discounted at the WACC, is the
value of operations (VOP).
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Nonoperating Assets

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Nonoperating assets are securities
Value of nonoperating assets is usually
close to the figure on balance sheet.
Often, firms have little invested in
marketable securities.
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What are operating current
assets?

Operating current assets are the CA
needed to support operations.

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Op CA: cash, inventory, receivables
(current assets that do not earn interest)
Op CA exclude: short-term investments,
because these are not a part of operations.
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What are operating current
liabilities?

Operating current liabilities are the CL
resulting as a normal part of operations.

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Op CL: accounts payable and accruals
(current liabilities that do not charge
interest)
Op CL exclude notes payable because this
is a source of financing, not a part of
operations.
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Net Operating Working Capital
(NOWC)
Operating
Operating
NOWC =
CA
CL
Net Op WC represents working
capital financed by investors.
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Total net operating capital
(also called operating capital)

Operating Capital= NOWC + Net fixed
assets.
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Calculating FCF

To determine FCF, we must first
calculate net operating profit after tax
(NOPAT):
NOPAT = EBIT(1 – tax rate)
NOPAT is the a firm would generate if it had
no debt and held no financial assets.
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Calculating FCF
FCF = NOPAT – net investment in
operating assets
Net investment is investment in excess of
depreciation expense
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Data for Valuation
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FCF0 = $20 million
WACC = 10%
g = 5%
Marketable securities = $100 million
Debt = $200 million
Preferred stock = $50 million
Book value of equity = $210 million
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Constant Growth Formula

If the growth rate is constant:
VOp =
FCF1
(WACC - g)
FCF0(1+g)
=
(WACC - g)
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Find Value of Operations
VOp
FCF0 (1 + g)
=
(WACC - g)
20(1+0.05)
= 420
VOp =
(0.10 – 0.05)
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Total Corporate Value

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Total corporate value is sum of:
 Value of operations (VOP)
 Value of nonoperating assets
Total Corp Value = VOP + Mkt Sec
= $420 + $100
= $520 mil
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Claims on Corporate Value

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Debtholders have first claim.
Preferred stockholders have the next
claim.
Any remaining value belongs to
common stockholders.
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Value of Equity

Total corporate value

Com equity value
= VOp + Mkt. Sec.
= $420 + $100
= $520 million
= Total - Debt - Pref.
= $520 - $200 - $50
= $270 million
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Per Share Value

To get value per share, divide the value
of common equity by the number of
shares.
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Horizon Value

If the expected growth in free cash
flows during the forecast period is not
constant, we cannot use the constant
growth formula to find the value of
operations at time 0.
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Horizon Value (cont.)

However, if growth is constant after the
planning period, we can find the value
of all free cash flows beyond the
horizon discounted back to the horizon.
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Horizon Value Formula
FCF
(1+g)
t
HV = VOp at time t =
(WACC - g)

Horizon value is also called terminal
value, or continuing value.
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Value of Operations with nonconstant Growth

If growth is non-constant, the value of
operations at t = 0 is the PV of FCFs
during the planning period, plus the PV
of the horizon value, all discounted at
the WACC.
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