FIN 468: Intermediate
Corporate Finance
Topic 5–Free Cash Flow
Larry Schrenk, Instructor
1 (of 22)
Exam 1 Structure


Length
Format



Short Answer
Calculations
Materials


1 hour
100 Points
50 Points
50 Points
(10 Questions)
(5-8 Questions)
Financial Calculator
No Crib Sheets, Formulae Sheets, etc.
You only need to know the formulae for ratios
mentioned on slides or discussed in class.
2 (of 70)
Exam Short Answer Preparation

Slides and Notes


Main Ideas
Textbook





Main Ideas
Learning Outcomes
Bold Terms
Chapter Summaries
EoC Problems: Conceptual Issues
3 (of 70)
Exam Calculation Preparation

Slides and Notes


Main Calculations
Textbook


Calculations in Text
EoC Problems: Calculations
4 (of 70)
Topics

Why Free Cash Flow (FCF)?

The Free Cash Flow Method

Problems with Free Cash Flow

Free Cash Flow Example
Why Free Cash Flow?
Dividends versus FCF

Dividends


Cash Flows Actually Paid to Stockholders
Free Cash Flows

Cash Flows Available for Distribution
7 (of 70)
Problems with DDM







Distribution, not Creation, of Value
Arbitrary and Hard to Predict
Retained Earnings Problem
Much Value Far in the Future
Cannot use to Value Firm
Agency Issues
Cash flows should reflect ability to pay
dividends, not what was actually paid
FCF Situations

No Dividends

Dividend Differ from Capacity to Pay

Free Cash Flows Align with Profitability

Control Perspective
9 (of 70)
The Free Cash Flow
Method
10 (of 70)
Free Cash Flow

Free Cash Flow = Cash Flow Available


No Definition


Available???
Like Ratios
Theoretical, not Observable, Value
11 (of 70)
FCFF versus FCFE

Free Cash Flow–Firm (FCFF)



Enterprise Cash Flow
Value the Entire Firm
Free Cash Flow–Equity (FCFE)


Value Equity
Issue: Preferred Shares
12 (of 70)
Free Cash Flow–Firm (FCFF)

Cash Flow Available to…





Repay Lenders
Pay Common and Preferred Dividends
Repurchase Equity
Call Debt
Adjustments to Net Income




Interest and Principal Payments
Non-Cash Items
Δ Working Capital
Δ Capital Expenditures
13 (of 70)
Free Cash Flow–Firm (FCFF)
Net Income
+ Interest and Principal Payments
+
Non-Cash Items (e.g., Depreciation)
–
ΔNet Working Capital
– Δ Capital Expenditures
FCFF
14 (of 70)
Free Cash Flow–Equity (FCFE)

Cash Flow Available to…




Repay Lenders
Pay Common and Preferred Dividends
Repurchase Equity
Adjustments to Net Income




Interest and Principal Payments
Non-Cash Items
Δ Working Capital
Δ Capital Expenditures
15 (of 70)
Free Cash Flow–Equity (FCFE)
Net Income
+ Non-Cash Items (e.g., Depreciation)
–
ΔNet Working Capital
– Δ Capital Expenditures
FCFE
16 (of 70)
Alternate FCFE Method

Derive Value form FCFF
FCFF
– Value of Debt
FCFE
17 (of 70)
Possible CF Growth Patterns
FCF Constant


FCF Changing at Constant Rate


Constant Growth Assumption
Neither


18
No-Growth Assumption
Variable Growth Assumption
The Cash Flows

The Income Statement



Net Income
Use This Method
The Statement of Cash Flows

Cash Flow from Operations
19 (of 70)
Interest and Principal Payments

After Tax Interest Payment


Interest x (1 – tc)
Principal Repayment?

Target Capital Structure
20 (of 70)
Non-Cash Adjustments
Non-Cash Item
Adjustment to Net Income
Depreciation
Amortization of intangibles
Restructuring Charges (expense)
Losses
Gains
Amortization of long-term bond discounts
Amortization of long-term bond premium
Deferred Taxes
Added Back
Added Back
Added Back
Added Back
Subtracted
Added Back
Subtracted
None
21 (of 70)
Forecasting Cash Flows

Historical Data




Historical Growth Rate
Best for Constant Growth
Past Predictive of Future
New Information
22 (of 70)
Forecasting Capital Expenditures

Two Components

Net Expenditures to Maintain Assets-in-Place

New Expenditures to Support Growth
Opportunities
23 (of 70)
Terminal value

Firms are Infinite

Perpetuity or Growing Perpetuity

WARNING: Delayed Perpetuity
24 (of 70)
Discount Rate

FCFF


FCFE


WACC
Required Return on Equity
More in Cost of Capital
25 (of 70)
Problems with Free Cash
Flow
26 (of 70)
Technical Problems


Free cash flow forecasts are generally not
available
Generally must compute statement of cash
flows from:



earnings forecasts
balance sheet assumptions
Much of value comes far in the future
Capital Expenditures


“Cash flow available to the firm’s suppliers of
capital after all operating expenses have
been paid and necessary investments in
working capital and fixed capital have been
made.”
What is ‘necessary’?”
28 (of 70)
Growth Estimation

Past versus Future

Sensitivity
29 (of 70)
Free Cash Flow
Example
30 (of 70)
Income Statement
Income Statement
Revenues
Costs and operating expenses
Cost of product sales
Selling, general and administrative
Depreciation and amortization
Research and development
Bad debt provisions
Total costs and operating expenses
Operating income
Other income (expense)
Interest income
Interest expense
$644,400,000
Other
Total other income (expense)
Income before tax
Income tax provisions
Net income
Dividends
$700,000
$5,300,000
$198,000,000
$74,000,000
$124,000,000
$24,000,000
$294,200,000
$92,900,000
$20,000,000
$44,400,000
$200,000
$451,700,000
$192,700,000
$15,900,000
($11,300,000)
31 (of 70)
Parameters

Rates



12%
17%
Adjustments



WACC
Return on Equity
ΔNet Working Capital
ΔCapital Expenditures
$5,000,000
$35,000,000
Growth Rates


g1-4
g5+
20%
2%
32 (of 70)
Initial FCFF
FCFF
Interest and Principal Payments
Depreciation
D Net Working Capital
D Capital Expenditures
$7,076,768
$20,000,000
$5,000,000
$35,000,000
FCFF
111,076,768
Note: Interest and Principal Payments are After-Tax
+
+
–
–
33 (of 70)
FCFF Valuation
1
20%
$133,292,121
Growth
FCFF
Terminal Value
PV (Annual)
$119,010,823
PV (ST)
$529,520,092
PV (LT)
$1,493,056,693
Value
$2,022,576,785
FCFF Model
2
3
20%
20%
$159,950,545 $191,940,655
4 5+
20%
$230,328,785
$127,511,596
$146,378,107
$136,619,567
2%
$234,935,361
$2,349,353,612
$1,493,056,693
34 (of 70)
Initial FCFE
FCFE
Depreciation
D Net Working Capital
D Capital Expenditures
FCFF
$20,000,000 +
$5,000,000 –
$35,000,000 –
$104,000,000
35 (of 70)
FCFE Valuation
1
20%
$124,800,000
Growth
FCFF
Terminal Value
PV (Annual)
$106,666,667
PV (ST)
$443,359,238
PV (LT)
$782,571,071
Value
$1,225,930,309
FCFE Model
2
3
20%
20%
$149,760,000 $179,712,000
4 5+
20%
$215,654,400
$109,401,709
$115,083,981
$112,206,881
2%
$219,967,488
$1,466,449,920
$782,571,071
36 (of 70)