Chapter 4 Free Cash Flows to Equity Frim
Transcript of Chapter 4 Free Cash Flows to Equity Frim
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Free cash flows to equity/firm
Chapter -4
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Learning Objectives
Introduction
Forecasting FCFE/FCFF
Equity of cost of capital
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Valuing the Firm
Economic theory teaches us that the value of an
investment is:
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Expected future payoffs can be measured in
terms of:
Dividends Cash Flows
Earnings
n
t t
tV1
0
Rate)Discount(1
PayoffsFutureProjected
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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
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Amount of cash flowing into firm differs from
dividends paid in a particular period.
But over the lifetime of the firm, cash flowsinto and cash flows out of the firm will be
equal.
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Cash-Flow-Based Valuation (Contd.)
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Cash is the ultimate source of value. The
free cash flows approach measures value
based on the cash flows that the firmgenerates that can be distributed to
investors.
It is a measurable common denominatorfor comparing the future benefits of
alternative investment instruments.
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Rationale for Using Free-Cash-Flows
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Cost of Common Equity Capital
CAPM Model:
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Weighted Average Cost of Capital
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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 thefewest 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 rateRE.
Expected future free cash flowsFCFEq forperiods 1 through Tover forecast horizon.
Continuing free cash flows, FCFEq(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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rateGrowth
capitalequityonreturnofrateRequired
rsshareholdeequitycommonforflowscashFree
firmaofequitycommontheofvaluePresent
Where,
g
R
FCFE
V
])R/([g)]/(R[][FCFE)R(
FCFEV
E
T
t
T
EETtE
t
0
1
10111
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Free-Cash-Flows-Based Valuation Models
For all debt and equity capital stakeholders:
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rateGrowth
capitalofcostaverageweightedfutureExpected
rsstakeholdecapitalequityanddebtallforflowscashFree
firmaofassetsoperatingnetofvaluePresent
Where,
g
R
FCFA
VNOA
])R/([g)]/(R[][FCFA
)R(
FCFAVNOA
A
T
t
T
AATt
A
t
0
1
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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. RAmust be greater than g for this formula to
work.
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])R/([g)]/(R[][FCFA T
AAT
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What now?
Once valuation model is applied, then
Conduct sensitivity analysis:
Vary cost of equity capital rate (RE)
Vary long-run growth rate (g)
Discount rate assumptions
Vary these parameters and assumptionsindividually 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 thanearnings.
Results from projections of futureoperating, 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 capitalproviders. This perspective is especiallypertinent 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 totalvalue but is sensitive to assumptions growthrates and discount rates.
Free cash flow computations must be
internally consistent with long-runassumptions 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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