FREE-CASHFLOWS TO FIRMS

PROF. NAVEEN BHATIA 1

FREE CASH FLOW TO A FIRM
 FCFF= EBIT X (1-TAX RATE) +DEPN -CAPEX INCREASE IN WC
 FCFF= FCFE + INT X (1-TR) + PRINCIPAL REPAYMENTS- NEW DEBT
ISSUES + PREFFEREFD DIVIDENDS.
 IMP. – FCFF DOESN’T CONSIDER ANY OF THE TAX BENEFITS DUETO
INTEREST PAYMENTS, WHICH IS ALREADY CONSIDERED IN COC AND
INCLUDING THIS IN THE CASH FLOWS WOULD BE DOUBLE COUNTING IT.

 EXPECTED GROWTH IN OP. INCOME= REINVESTMENT RATE * ROC

 RETURN ON CAPITAL=EBIT ( 1-T) DIVIDE BY ( BV OF DEBT + BV OF EQUITY)
 REINVESTMENT RATE= G/ROC

PROF. NAVEEN BHATIA 2

FREE CASH FLOW TO A FIRM
 STABLE GROWTH FIRM:
 VALUE OF FIRM= FCFF1/ ( WACC- gn)
 REINVESTMENT RATE= GROWTH RATE/ ROC
 GROWTH RATE<= NOMINAL GROWTH &
 IF REINVESTMENT IS ESTIMATED FROM THE NET CAPEX AND CHANGE IN
WC , THEN LOOK AT THE INDUSTRY AVERAGES.
 THE BETA SHOULD BE CLOSE TO 1 ( BETWEEN 0.8 & 1.0)
 AGAIN IN THIS MODEL , FRIST WE DETERMINE THE VALUE OF OPERATING
ASSETS. REMEMBER OP. EARNINGS DON’T INCLUDE THE EARNINGS FROM
NON OPERATING ASSETS.
 TO THE VALUE OF OPERATING ASSETS SO OBTAINED ,WE ADD THE VALUE
OF CASH & NON- OPERATING ASSETS AND SUBTRACT THE VALUE OF DEBT
TO OBTAIN THE VALUE OF EQUITY.

PROF. NAVEEN BHATIA 3

FREE CASH FLOW TO A FIRM
 MARKET VALUE WTS , CIRCULAR PROBLEMS AND COC:”
 WE FIRST ESTIMATE THE VALUE BY USING THE CURRENT MPRICE TO
DETERMINE THE WT. OF EQUITY.
 USING FCFF VLUATION , IF WE GET A LOWER INTINSIC VALUE, & WE USE
THIS VALUE FOR DETERMINING THE WT OF EQUITY IN COC, WE WILL NOW
GET A HIGHER INTRINSIC VALUE.
 THIS ITERATIVE PROCESS CAN GO ON TILL THE TWO VALUES ( IV AND THE
VALUE USED TO DETERMINE THE WEIGHT) CONVERGE.
 FOR EXAMPLE IF YOU START WITH A MV OF 92.70 AND ESTIMATE THE IV AT
63.66 AND THEN USING ITERATIVE PROCESS, WE WILL ESTIMATE A VALUE
OF 70.66 PER SHARE.

 TWO –STAGE AND THREE- STAGE GROWTH MODEL:

 SAME ASSUMPTIONS AND MODEL AS THAT FOR FCFE

PROF. NAVEEN BHATIA 4

FREE CASH FLOW TO A FIRM
 FCFE VS FCFF:
 THE VALUE FOR THE EQUITY OBTAINED FROM THE FIRM VALUATION EQUITY
VALUATION WILL BE SAME IF ONE MAKES CONSISTEMNT ASSUMPTION
ABOUT FINANCIAL LEVERAGES.
 A COST OF CAPITAL BASED ON MARKET VALUE WTS WILL NOT YIELD THE
SAME VALUE FOR EQUITY AS AN EQUITY VALUATION MODEL IF THE FIRM IS
NOT FAIRLY PRICED.
 THE INTEREST EXPENSES ARE EQUAL TO THE PRETAX COST OF DEBT
MULTIPLIED BY MV OF DEBT. OF A FIRM HAS OLD DEBT ON ITS BOOKS, WITH
INTEREST EXPENSES THAT ARE DIFFERENT FROM THIS VALUE, THE FCFE &
FCFF APPROACH WILL DIVERGE.

PROF. NAVEEN BHATIA 5

FREE CASH FLOW TO A FIRM
 EFFECT OF LEVERAGE ON A FIRMS VALUATION:
 VALUE OF FIRM= SUM OF FCFF/ ( 1+WACC)
 IF WE ASSUME THAT FCFF ARE NOT AFFECTED BY THE CHOICE OF THE
FINANCING MIX ( REMEMBER THEY ARE CASH FLOWS BEFORE INT ) AND
THE COC REDUCES WITH THE INCREASING LEVERAGE THEN THE VALUE OF
FIRM WILL INCREASE.
 THUS IF FCFF ARE UNAFFCTED BY LEVERAGE THE VALUE OF THE FIRM IS
MAXIMISED BY MINIMISING THE COC.
 RECALL THAT BETA ( LEVERED) = B(UL) (1+(1-T)X D/E)
 THUS IF WE CAN ESTIMATE THE UNLEVERED BETA FOR A FIRM, WE CAN USE
IT TO ESTIMATE THE LEVERED BETA OF A FIRM FOR EVERY DEBT RATIO.
 COST OF EQUITY= RFR + BETA ( LEVERED) ( RISK PREMIUM)
 THE COST OF DEBT FOR A FIRM IS A FUNCTION OF THE FIRM’S DEFAULT
RISK.
 WE CAN NOW MEASURE THE FIRM’S WACC.

PROF. NAVEEN BHATIA 6

FREE CASH FLOW TO A FIRM
 DEFAULT RISK, OPERATING INCOME & OPTIMAL LEVERAGE
 THE OPERATING INCOME FOR MANY FIRMS WILL DROP AS THE DEFAULT
RISK INCREASES.
 THE DROP IS LIKELY TO BE MORE PRONOUNCED AS THE DEFAULT RISK
FALLS BELOW AN ACCEPTABLE LEVEL.
 FOR EXAMPLE , A BOND RATING BELOW INVESTMENT GRADE MAY TRIGER
SIGNIFICANT LOSSES IN REVENUES AND INCREASE IN EXPENSES.
 IN SUCH A SCENARIO MAXIMISING A FIRMS VALUE REQUIRES LOOKING AT
BOTH THE FIRMS CASH FLOWS AND THE WACC.

PROF. NAVEEN BHATIA 7