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CRICOS code 00025B
Stock valuation (2)
What is free cash flow?
• Cash flows into the company as it sells its products or provide services
• Cash flows out as it pays its cash operating expenses (e.g.. salaries and taxes, admin costs)
• Then the firm takes the leftover cash and makes short-term net investments in working capital
(e.g. inventory and receivables) and long-term net investments in property, plant and
equipment (PP&E).
• Remaining cash is free cash flow to the firm (FCFF) and available to pay out to the firm’s
investors
- Bondholders
- Shareholders
• The cash that is left after the firm has met all its obligations to other investors is free cash
flow to equity (FCFE).
Free cash flow model
2
CRICOS code 00025B
Firm value = FCFF discounted at the WACC
Equity value = FCFE discounted at the required return on equity
Equity value = firm value – market value of debt
Why use free cash flow model?
• Many firms pay no, or low, cash dividends.
• Dividends are paid at the discretion of the board of directors, hence may be poorly aligned with
the firm’s long-run profitability.
• Free cash flows may be more related to long-run profitability of the firm as compared to
dividends.
Free cash flow model
3
CRICOS code 00025B
Calculate FCFF from net income
FCFF = NI + [Interest*(1 – tax rate)] + NCC – FCInv – WCInv
NCC: non cash charge
- Added back to net income because they represent expenses that reduced reported net
income but didn’t actually result in an outflow of cash.
- Depreciation and amortisation
FCInv: Fixed capital investment
- Investments in fixed capital do not appear on the income statement, they do represent cash
leaving from the firm.
- FCInv = capital expenditure – proceeds from sales of long-term assets
WCInv: working capital investment
- Investment in net working capital.
Free cash flow model
[Presentation Title] [Date] 4
CRICOS code 00025B
Calculate FCFF from EBIT and EBITDA
FCFF = EBIT(1-tax rate) + Dep – FCInv – WCInv
FCFF = EBITDA(1-tax rate) + Dep*tax rate – FCInv – WCInv
Calculate FCFE directly from FCFF
FCFE = FCFF – [Interest*(1 – tax rate)] + net borrowing
Net borrowing = new debt issues – debt repayments
Free cash flow valuation model
Single stage constant growth model
Two, three or multi-stage model
Free cash flow model
5
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CRICOS code 00025B
Free cash flow model
6
where market value of equity and debt is applied
• Firm value is the present value of expected free cash flow to the firm (FCFF), discounted
at the weighted average cost of capital (WACC).
• Replacing FCFF and WACC using FCFE and required return on equity, respectively gives
the equity value.
• Equity value is firm value less the market value of debt.
• Under consistent assumptions about growth and capital structure, DDM and FCFF provide
exactly the same valuation.
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CRICOS code 00025B
• Firm value assuming constant growth in the terminal state
Free cash flow to the firm model (2)
7
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CRICOS code 00025B
Example:
Zoe Ltd had a net profit margin of 25% on revenues of $30 million this year. Fixed capital
investment was $3million. Depreciation was also $3 million. Working capital investment is 7.5%
of total sales. Net income, fixed capital investment, depreciation, interest expense, and sales
are expected to increase at 10% per year for the next three years, after which, the growth will be
stable at 4% per year. Tax rate is 40% and the company has 1 million shares outstanding. The
company’s long term debt has market value of $30million. Interest rate is 10%. What is the firm
value and the firm’s equity value. Use FCFF model and assume WACC is 18% during the high-
growth stage and 13% during the stable stage.
Free cash flow
8
CRICOS code 00025B
Residual income
• The net income of a firm less a charge that measures stockholders’ opportunity cost of capital.
• Recognises the cost of equity capital in the measurement of income.
• Explicitly deducts all capital costs, unlike accounting net income which only deducts cost of
debt.
Et = expected EPS for year t
ke = required return on equity
Bt-1 = book value of equity in year t –1
Residual income model
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CRICOS code 00025B
Equity value is the book value of equity plus the present value of expected residual income.
Residual income is the excess earnings above what would be earned if the book value of
equity earned a return just equal to the cost of equity capital.
Book value of equity is typically well below market value of equity, so it is usual to expect
positive residual income.