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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 gWACC gFCFF gWACC FCFF V )1(01 n t nt t t t t WACCWACC FCFF WACC FCFF V 11 1 firm of valueTerminal )1()1( 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. V D k V E kWACC de 1 CRICOS code 00025B • Firm value assuming constant growth in the terminal state Free cash flow to the firm model (2) 7 n n n t t t WACCgWACC FCFF WACC FCFF V 1)1( 1 1 )( capitalon return Expectedratent Reinvestme ROCERR g capexSustainingWCInvDeptEBIT RR 1 capex sustaining-capex Total assets gmaintaininon capex after availableCash sinvestment newfor Capex 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 9 11 )()( tetett BkROEBkERI 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.