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FIN 468: Intermediate Corporate Finance

FIN 468: Intermediate Corporate Finance. Topic 5–Free Cash Flow Larry Schrenk, Instructor. Exam 1 Structure. Length 1 hour Format 100 Points Short Answer 50 Points (10 Questions) Calculations 50 Points (5-8 Questions) Materials Financial Calculator

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FIN 468: Intermediate Corporate Finance

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  1. FIN 468: Intermediate Corporate Finance Topic 5–Free Cash Flow Larry Schrenk, Instructor

  2. Exam 1 Structure • Length 1 hour • Format 100 Points • Short Answer 50 Points (10 Questions) • Calculations 50 Points (5-8 Questions) • Materials Financial Calculator • No Crib Sheets, Formulae Sheets, etc. • You only need to know the formulae for ratios mentioned on slides or discussed in class.

  3. Exam Short Answer Preparation • Slides and Notes • Main Ideas • Textbook • Main Ideas • Learning Outcomes • Bold Terms • Chapter Summaries • EoC Problems: Conceptual Issues

  4. Exam Calculation Preparation • Slides and Notes • Main Calculations • Textbook • Calculations in Text • EoC Problems: Calculations

  5. Topics • Why Free Cash Flow (FCF)? • The Free Cash Flow Method • Problems with Free Cash Flow • Free Cash Flow Example

  6. Why Free Cash Flow?

  7. Dividends versus FCF • Dividends • Cash Flows Actually Paid to Stockholders • Free Cash Flows • Cash Flows Available for Distribution

  8. Problems with DDM • Distribution, not Creation, of Value • Arbitrary and Hard to Predict • Retained Earnings Problem • Much Value Far in the Future • Cannot use to Value Firm • Agency Issues • Cash flows should reflect abilityto pay dividends, not what was actually paid

  9. FCF Situations No Dividends Dividend Differ from Capacity to Pay Free Cash Flows Align with Profitability Control Perspective

  10. The Free Cash Flow Method

  11. Free Cash Flow • Free Cash Flow = Cash Flow Available • Available??? • No Definition • Like Ratios • Theoretical, not Observable, Value

  12. FCFF versus FCFE • Free Cash Flow–Firm (FCFF) • Enterprise Cash Flow • Value the Entire Firm • Free Cash Flow–Equity (FCFE) • Value Equity • Issue: Preferred Shares

  13. Free Cash Flow–Firm (FCFF) • Cash Flow Available to… • Repay Lenders • Pay Common and Preferred Dividends • Repurchase Equity • Call Debt • Adjustments to Net Income • Interest and Principal Payments • Non-Cash Items • Δ Working Capital • Δ Capital Expenditures

  14. Free Cash Flow–Firm (FCFF) Net Income + Interest and Principal Payments + Non-Cash Items (e.g., Depreciation) – ΔNet Working Capital – Δ Capital Expenditures FCFF

  15. Free Cash Flow–Equity (FCFE) • Cash Flow Available to… • Repay Lenders • Pay Common and Preferred Dividends • Repurchase Equity • Adjustments to Net Income • Interest and Principal Payments • Non-Cash Items • Δ Working Capital • Δ Capital Expenditures

  16. Free Cash Flow–Equity (FCFE) Net Income + Non-Cash Items (e.g., Depreciation) – ΔNet Working Capital – Δ Capital Expenditures FCFE

  17. Alternate FCFE Method Derive Value form FCFF FCFF – Value of Debt FCFE

  18. Possible CF Growth Patterns • FCF Constant • No-Growth Assumption • FCF Changing at Constant Rate • Constant Growth Assumption • Neither • Variable Growth Assumption

  19. The Cash Flows • The Income Statement • Net Income • Use This Method • The Statement of Cash Flows • Cash Flow from Operations

  20. Interest and Principal Payments • After Tax Interest Payment • Interest x (1 – tc) • Principal Repayment? • Target Capital Structure

  21. Non-Cash Adjustments Non-Cash ItemAdjustment to Net Income Depreciation Added Back Amortization of intangibles Added Back Restructuring Charges (expense) Added Back Losses Added Back Gains Subtracted Amortization of long-term bond discounts Added Back Amortization of long-term bond premium Subtracted Deferred Taxes None

  22. Forecasting Cash Flows • Historical Data • Historical Growth Rate • Best for Constant Growth • Past Predictive of Future • New Information

  23. Forecasting Capital Expenditures • Two Components • Net Expenditures to Maintain Assets-in-Place • New Expenditures to Support Growth Opportunities

  24. Terminal value Firms are Infinite Perpetuity or Growing Perpetuity WARNING: Delayed Perpetuity

  25. Discount Rate • FCFF • WACC • FCFE • Required Return on Equity • More in Cost of Capital

  26. Problems with Free Cash Flow

  27. Technical Problems • Free cash flow forecasts are generally not available • Generally must compute statement of cash flows from: • earnings forecasts • balance sheet assumptions • Much of value comes far in the future

  28. Capital Expenditures “Cash flow available to the firm’s suppliers of capital after all operating expenses have been paid and necessary investments in working capital and fixed capital have been made.” What is ‘necessary’?”

  29. Growth Estimation Past versus Future Sensitivity

  30. Free Cash Flow Example

  31. Income Statement

  32. Parameters • Rates • WACC 12% • Return on Equity 17% • Adjustments • ΔNet Working Capital $5,000,000 • ΔCapital Expenditures $35,000,000 • Growth Rates • g1-4 20% • g5+ 2%

  33. Initial FCFF

  34. FCFF Valuation

  35. Initial FCFE

  36. FCFE Valuation

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