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Chapters 7 & 11

Chapters 7 & 11. Corporate Valuation Based on Free Cash Flows (FCF). Corp. Valuation Based on Free Cash Flows (FCF). The Free Cash Flow Valuation model can be applied to a firm that does not pay dividends, a privately held firm, or to a division of a firm.

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Chapters 7 & 11

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  1. Chapters 7 & 11 Corporate Valuation Based on Free Cash Flows (FCF)

  2. Corp. Valuation Based on Free Cash Flows (FCF) • The Free Cash Flow Valuation model can be applied to a firm that does not pay dividends, a privately held firm, or to a division of a firm.

  3. What is free cash flow (FCF) & why is it important? • FCF is the cash from operations available for distribution to investors (stockholders and debtholders) after making the necessary investments to support operations. • A company’s value depends upon the amount of FCF it can generate.

  4. Free Cash Flow Valuation • The FCF approach estimates total enterprise value, rather than the value of equity or per share value directly. • The value of equity (& per share value) can be obtained from the total value by netting out other claims.

  5. FCF Valuation • To use the FCF model, we must: • Distinguish between operating assets and nonoperating assets • Calculate FCF

  6. Operating Assets • Operating assets: • Tangible, necessary to operate the business • Usually expected to grow • Generate free cash flows • The PV of expected future free cash flows, discounted at the WACC, is the value of operations (VOP).

  7. Nonoperating Assets • Nonoperating assets are securities • Value of nonoperating assets is usually close to the figure on balance sheet. • Often, firms have little invested in marketable securities.

  8. What are operating current assets? • Operating current assets are the CA needed to support operations. • Op CA: cash, inventory, receivables (current assets that do not earn interest) • Op CA exclude: short-term investments, because these are not a part of operations.

  9. What are operating current liabilities? • Operating current liabilities are the CL resulting as a normal part of operations. • Op CL: accounts payable and accruals (current liabilities that do not charge interest) • Op CL exclude notes payable because this is a source of financing, not a part of operations.

  10. Operating CA Operating CL NOWC = - Net Operating Working Capital (NOWC) Net Op WC represents working capital financed by investors.

  11. Total net operating capital (also called operating capital) • Operating Capital= NOWC + Net fixed assets.

  12. Calculating FCF • To determine FCF, we must first calculate net operating profit after tax (NOPAT): NOPAT = EBIT(1 – tax rate) NOPAT is the a firm would generate if it had no debt and held no financial assets.

  13. Calculating FCF FCF = NOPAT – net investment in operating assets Net investment is investment in excess of depreciation expense

  14. Data for Valuation • FCF0 = $20 million • WACC = 10% • g = 5% • Marketable securities = $100 million • Debt = $200 million • Preferred stock = $50 million • Book value of equity = $210 million

  15. FCF1 VOp = (WACC - g) FCF0(1+g) = (WACC - g) Constant Growth Formula • If the growth rate is constant:

  16. FCF0 (1 + g) VOp = (WACC - g) 20(1+0.05) VOp = = 420 (0.10 – 0.05) Find Value of Operations

  17. Total Corporate Value • Total corporate value is sum of: • Value of operations (VOP) • Value of nonoperating assets • Total Corp Value = VOP + Mkt Sec = $420 + $100 = $520 mil

  18. Claims on Corporate Value • Debtholders have first claim. • Preferred stockholders have the next claim. • Any remaining value belongs to common stockholders.

  19. Value of Equity • Total corporate value = VOp + Mkt. Sec. = $420 + $100 = $520 million • Com equity value = Total - Debt - Pref. = $520 - $200 - $50 = $270 million

  20. Per Share Value • To get value per share, divide the value of common equity by the number of shares.

  21. Horizon Value • If the expected growth in free cash flows during the forecast period is not constant, we cannot use the constant growth formula to find the value of operations at time 0.

  22. Horizon Value (cont.) • However, if growth is constant after the planning period, we can find the value of all free cash flows beyond the horizon discounted back to the horizon.

  23. FCFt(1+g) VOp at time t HV = = (WACC - g) Horizon Value Formula • Horizon value is also called terminal value, or continuing value.

  24. Value of Operations with non-constant Growth • If growth is non-constant, the value of operations at t = 0 is the PV of FCFs during the planning period, plus the PV of the horizon value, all discounted at the WACC.

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