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FIN 468: Intermediate Corporate Finance Topic 5–Free Cash Flow Larry Schrenk, Instructor 1 (of 22) Exam 1 Structure Length Format Short Answer Calculations Materials 1 hour 100 Points 50 Points 50 Points (10 Questions) (5-8 Questions) Financial Calculator No Crib Sheets, Formulae Sheets, etc. You only need to know the formulae for ratios mentioned on slides or discussed in class. 2 (of 70) Exam Short Answer Preparation Slides and Notes Main Ideas Textbook Main Ideas Learning Outcomes Bold Terms Chapter Summaries EoC Problems: Conceptual Issues 3 (of 70) Exam Calculation Preparation Slides and Notes Main Calculations Textbook Calculations in Text EoC Problems: Calculations 4 (of 70) Topics Why Free Cash Flow (FCF)? The Free Cash Flow Method Problems with Free Cash Flow Free Cash Flow Example Why Free Cash Flow? Dividends versus FCF Dividends Cash Flows Actually Paid to Stockholders Free Cash Flows Cash Flows Available for Distribution 7 (of 70) 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 ability to pay dividends, not what was actually paid FCF Situations No Dividends Dividend Differ from Capacity to Pay Free Cash Flows Align with Profitability Control Perspective 9 (of 70) The Free Cash Flow Method 10 (of 70) Free Cash Flow Free Cash Flow = Cash Flow Available No Definition Available??? Like Ratios Theoretical, not Observable, Value 11 (of 70) 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 12 (of 70) 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 13 (of 70) Free Cash Flow–Firm (FCFF) Net Income + Interest and Principal Payments + Non-Cash Items (e.g., Depreciation) – ΔNet Working Capital – Δ Capital Expenditures FCFF 14 (of 70) 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 15 (of 70) Free Cash Flow–Equity (FCFE) Net Income + Non-Cash Items (e.g., Depreciation) – ΔNet Working Capital – Δ Capital Expenditures FCFE 16 (of 70) Alternate FCFE Method Derive Value form FCFF FCFF – Value of Debt FCFE 17 (of 70) Possible CF Growth Patterns FCF Constant FCF Changing at Constant Rate Constant Growth Assumption Neither 18 No-Growth Assumption Variable Growth Assumption The Cash Flows The Income Statement Net Income Use This Method The Statement of Cash Flows Cash Flow from Operations 19 (of 70) Interest and Principal Payments After Tax Interest Payment Interest x (1 – tc) Principal Repayment? Target Capital Structure 20 (of 70) Non-Cash Adjustments Non-Cash Item Adjustment to Net Income Depreciation Amortization of intangibles Restructuring Charges (expense) Losses Gains Amortization of long-term bond discounts Amortization of long-term bond premium Deferred Taxes Added Back Added Back Added Back Added Back Subtracted Added Back Subtracted None 21 (of 70) Forecasting Cash Flows Historical Data Historical Growth Rate Best for Constant Growth Past Predictive of Future New Information 22 (of 70) Forecasting Capital Expenditures Two Components Net Expenditures to Maintain Assets-in-Place New Expenditures to Support Growth Opportunities 23 (of 70) Terminal value Firms are Infinite Perpetuity or Growing Perpetuity WARNING: Delayed Perpetuity 24 (of 70) Discount Rate FCFF FCFE WACC Required Return on Equity More in Cost of Capital 25 (of 70) Problems with Free Cash Flow 26 (of 70) 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 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’?” 28 (of 70) Growth Estimation Past versus Future Sensitivity 29 (of 70) Free Cash Flow Example 30 (of 70) Income Statement Income Statement Revenues Costs and operating expenses Cost of product sales Selling, general and administrative Depreciation and amortization Research and development Bad debt provisions Total costs and operating expenses Operating income Other income (expense) Interest income Interest expense $644,400,000 Other Total other income (expense) Income before tax Income tax provisions Net income Dividends $700,000 $5,300,000 $198,000,000 $74,000,000 $124,000,000 $24,000,000 $294,200,000 $92,900,000 $20,000,000 $44,400,000 $200,000 $451,700,000 $192,700,000 $15,900,000 ($11,300,000) 31 (of 70) Parameters Rates 12% 17% Adjustments WACC Return on Equity ΔNet Working Capital ΔCapital Expenditures $5,000,000 $35,000,000 Growth Rates g1-4 g5+ 20% 2% 32 (of 70) Initial FCFF FCFF Interest and Principal Payments Depreciation D Net Working Capital D Capital Expenditures $7,076,768 $20,000,000 $5,000,000 $35,000,000 FCFF 111,076,768 Note: Interest and Principal Payments are After-Tax + + – – 33 (of 70) FCFF Valuation 1 20% $133,292,121 Growth FCFF Terminal Value PV (Annual) $119,010,823 PV (ST) $529,520,092 PV (LT) $1,493,056,693 Value $2,022,576,785 FCFF Model 2 3 20% 20% $159,950,545 $191,940,655 4 5+ 20% $230,328,785 $127,511,596 $146,378,107 $136,619,567 2% $234,935,361 $2,349,353,612 $1,493,056,693 34 (of 70) Initial FCFE FCFE Depreciation D Net Working Capital D Capital Expenditures FCFF $20,000,000 + $5,000,000 – $35,000,000 – $104,000,000 35 (of 70) FCFE Valuation 1 20% $124,800,000 Growth FCFF Terminal Value PV (Annual) $106,666,667 PV (ST) $443,359,238 PV (LT) $782,571,071 Value $1,225,930,309 FCFE Model 2 3 20% 20% $149,760,000 $179,712,000 4 5+ 20% $215,654,400 $109,401,709 $115,083,981 $112,206,881 2% $219,967,488 $1,466,449,920 $782,571,071 36 (of 70)