Dick Sweeney
Notes on Valuing the Project/Company as a Whole
For valuing the project/company as a whole, we use the Free Cash Flow (FCF) approach
in this course. That is, we use the WACC approach to valuing a levered firm. This approach is
based on MM Proposition II with corporate taxes. Below are some notes on applying this
approach. The notes are designed to accompany Copeland, Tom, Tim Koller and Jack Murrin,
Valuation: Measuring and Managing the Value of Corporations, 2000. These notes are adapted
with kind permission from a paper that Allan Eberhart originally prepared.
A firm's free cash flow is defined as:
Free Cash Flow
=
Gross Cash Flow - Gross Investment
In turn,
Gross Cash Flow
=
+
Earnings Before Interest and Taxes (EBIT)
Taxes on EBIT
Change in Deferred Taxes
=
+
Net Operating Profit Less Adjusted Taxes (NOPLAT)
Depreciation and other non-cash expenses
(e.g., amortization and depletion)
=
Gross Cash Flow
and
Gross Investment
=
+
+
+
Increase in Operating Working Capital
Capital Expenditures
Investment in Goodwill
Increase in Net Other Assets (this can be a catch-all category)
=
Gross Investment
This gives Free Cash Flow as
Free Cash Flow
=
Gross Cash Flow - Gross Investment
By adding Non-operating Cash Flow,
Total After-Tax Cash Flow = Free Cash Flow + Non-operating Cash Flow
Note: Because FCF depends on changes in certain variables, you clearly cannot calculate FCF
for the first year for which you have financial information on the firm.
Explanations 1
Earnings Before Interest and Taxes (EBIT): This is often called "operating income" on the
firm's income statement. Be sure to remove any nonoperating income, if this is included:
Examples of nonoperating income (losses) are gains (losses) from the sale of assets; accounting
changes, etc.
Taxes on EBIT: These are the taxes the firm would pay if it had no debt or excess marketable
securities (note: ask whether the firm has excess marketable securities: Vick does not, but in later
1 The Copeland et al. book suggests calculating the firm’s financial flow as a check on
your calculation of total after-tax cash flows. The advantage of the financial flow approach is
that it highlights how the FCF is divided among the shareholders and the debtholders.
The firm's financial flow is defined as:
Financial Flow
Financial Flow
=
+
+
+
+
Change in Excess Marketable Securities
After-tax Interest Income
Decrease in Debt
After-tax interest expense
Dividends
Share repurchases
=
Financial Flow
=
Total After-tax Cash Flow
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years Corning does). Specifically, Taxes on EBIT are defined as:
Total income tax provision from income statement
+
Tax shield on interest expense
Tax on the company’s interest income
Tax on nonoperating income
______________________________
=
Taxes on EBIT
Change in Deferred Taxes The total income tax provision from the firm's reported income
statement generally is not equal to the firm's actual tax payment (e.g., because the firm uses
straight line depreciation for its reported earnings and MACRS for its earnings reported to the
IRS). An increase in deferred taxes means the firm has paid fewer taxes than it reported (and
vice versa). This will be listed on the liability side of the firm's balance sheet. If it is also listed
on the asset side, then subtract this amount from the liability amount and look at the change in
this difference. (Note: Firms are now required to report cash taxes paid and so you can put cash
taxes in directly; to be consistent with the definition in the Valuation book, however, you can just
use this indirect method.)
Net Operating Profit Less Adjusted Taxes (NOPLAT): This is the firm's after-tax profits, that
is, after adjusting the taxes to a cash basis.
Depreciation and other non-cash expenses: Depreciation is the major noncash expense you
need to worry about adding back to cash flow. More generally, for our purposes, we can add
back in depreciation, depletion and amortization.
Gross Cash Flow: This is the total after-tax cash flow produced by the firm. It is the amount the
firm has available for maintenance and growth investment without relying on additional capital.
Change in (operating) Working Capital: This is the amount the firm invests in working capital
over the year. Hence, it is the change in (current assets - current liabilities). Because this is
operating working capital, non-operating assets and interest-bearing liabilities are excluded (e.g.,
short-term debt should not be included; short-term debt includes notes payable and current
portion of long-term debt). Note: You should exclude non-operating cash from the operating
working capital definition; however, for our purposes, you are welcome to assume non-operating
cash is zero.
Capital Expenditures: This includes expenditures on new and replacement property, plant, and
equipment. It can be calculated as the increase in net property, plant, and equipment on the
balance sheet plus depreciation. Because depreciation and amortization are lumped together, you
can include them both here.
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Investment in Goodwill: This can be calculated as the change in intangibles plus any
amortization charge.
Increase in Net Other Assets: This is the increase in expenditures on all other assets. It can be
calculated from the change in the balance sheet item(s). Note: In general, the change in any longterm (operating) asset category not accounted for in capital expenditures or investment in
goodwill represents an investment (e.g., investment at equity) and should be put in this category.
Gross Investment: This is the total investment in new capital, including working capital, capital
expenditures, goodwill and other assets.
Non-operating Cash Flows: These are the after-tax cash flows from items not related to
operations. Examples include the proceeds from an asset sale, returns from financial investments
(assuming the firm is not some type of financial institution).
Change in Excess Marketable Securities Excess marketable securities are short-term cash
investments that the firm holds that are in excess of its target cash balances. You can estimate
this by examining other similar firms.
After-tax Interest Income: This is the pre-tax interest income (on excess marketable securities)
times one minus the marginal tax rate.
Change in Debt : This is the net borrowing or repayment on all of the firm's debt.
After-tax Interest Expense: This is the firm's pretax interest expense times 1 minus the firm's
marginal tax rate.
Dividends: This is the cash dividend paid to common and preferred shareholders.
Share Issues/Repurchases: If stock is issued, this is a negative number; if stock is repurchased,
this is a positive number.
The Free Cash Flow (FCF) Approach
Computing the firm's current FCF is relatively straightforward. Of course, firm value is
not determined by current FCF but forecasted FCF (discounted at the WACC, plus the present
value of nonoperating cash flows). Nevertheless, getting an accurate calculation of current FCF
is important because forecasted FCF is computed based on the growth in each component of the
current FCF.
The key to understanding the FCF approach is to think back to the separation theorem.
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This theorem says that the firm makes its investment decisions (i.e., capital budgeting decisions)
first and then decides how to finance these investments. With perfect markets, MM show that
the financing decision does not affect the value of the firm. With imperfections, capital structure
may affect the firm's investment policy (e.g., through indirect bankruptcy costs). Capital
structure may also affect the firm's WACC (as in the case of corporate taxes where interest
payments are tax deductible and dividend payments are not).
To keep things tractable, the FCF approach relies on the MM theory of capital structure
with corporate taxes. Thus, the firm's investment policy is presumed to be independent of the
capital structure. The relevance of capital structure is revealed in the WACC. Recall that at the
extreme, the MM theory suggests that the firm should use 100% debt financing. Of course, this
cannot be taken literally. The intelligent inference is that, at the margin, increasing the firm's
debt level will decrease the WACC. Ceteris paribus, this will increase value. You should not,
however, be lulled into such a simple, mechanical, increase in value; keep in mind that there can
be offsetting effects (e.g., bankruptcy costs, personal taxes, agency conflicts).
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