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Session 6 Lecture
Session 6 Lecture
Session 6 Lecture
whole (as opposed to valuing the debt or equity separately), we will use the WACC as the
discount factor. More will be said about the implicit assumptions and limitations of this
use later on.
Free Cash Flows
Free cash flows represent cash available for investors after all of the needs of
operating the business including its ability to operate in the future are met. The starting
point for calculating free cash flow is the net operating income after tax (the book uses
the term NOPAT, or net operating profit after taxgenerally speaking, income and profit
are the same). The net operating income typically includes all revenues and expenses that
relate to the day-to-day operation of the business. It does not include interest expenses or
any other financial cash flow. It is important to note that the differentiation here is
between operating and financial cash flows.
Operating revenues are earned and operating expenses incurred as a direct result
of applying corporate resources to do business. Financial cash flows, on the other hand,
relate to decisions the company has made regarding how it raises its capital. For
example, interest and principle payments are financial cash flows. These need to be paid
out of the operating cash flows. The companys ability to make these payments is an
important factor in determining its value. Since the payments are made out of the free
cash flows, the amounts are not deducted from the free cash flows in determining value.
In addition to the NOIAT, there are two other elements to the calculation of the
free cash flow. First is the new investment in net working capital required to sustain
business operations. As you know, net working capital is the difference between current
assets and current liabilities. When measuring current liabilities, however, it is important
to include only those that result from day-to-day operations. This would not include any
interest bearing liabilities such as notes payable. Notes payable relate to financial and not
operating cash flows. The impact of these will be picked up in the WACC.
The new investment in net working capital is measured by the change in the level
of net working capital required to sustain operations from year-to-year. For example, if
the current years net working capital level is $469MM, and next years required level is
$522MM, the new investment in net working capital is the difference between the two, or
$53MM.
The second element included in the determination of free cash flow is the net
investment in plant, property and equipment (fixed assets) needed to sustain the business
operation. This amount includes the increase (or decrease) in gross fixed assets (that is,
before accumulated depreciation) less the depreciation expense for that year. Subtracting
the depreciation expense is the same as adding it back to the free cash flow. This is
important because depreciation is a non-cash flow expense that is deducted from the net
operating income before taxes are calculated. Since it is available cash, however, it
should be included in the free cash flow calculation.
In order to determine the free cash flow for a year, it is necessary to have the
income statement for the year and the balance sheets from both the beginning and end of
the year. The first step is to identify the net operating income after tax (NOIAT or
NOPAT) and then adjust for operating net working capital and net new fixed investments.
An example is included in a spreadsheet named freecashflow.xls.
From the example you can see several important points. First, dividend payments
are not included in the calculation. Dividend payments are residual financial cash flows
and are not part of the operating free cash flow. Next, note that the notes payable are not
included in the calculation for the same reason. The example shows an operating free
cash flow made up of the following:
Free Cash Flow Calculation for 2003E
2002
EBIT
Taxes at 40%
NOIAT (NOPAT)
Change in Operating Net Working Capital
Operating Current Assets (Total Current)
Change in Operating Current Assets (2003E-2002)
Operating Current Liabilities (A/P and accruals)
Change in Operating Current Liabilities (2003E-2002)
$9,471
($3,788)
$5,683
$5,610
$2,652
2003E
$6,292
$682
$3,105
$453
$229
$13,200
$15,700
$2,500
($1,320)
$1,180
$5,683
($229)
($1,180)
$4,273
of any cash flow earned by the company beyond the end of the five to ten year forecast
period. The present value of these cash flows constitutes what is referred to as the
horizon or continuation value of the company. Calculating this value is important
because we assume that a company is a going concern with a theoretically unlimited life
as an entity. To determine this horizon value, we can take advantage of the constant
growth stock valuation model we learned in Session 4.
Suppose we have a five-year financial forecast, and that the operating cash flow
for the fifth year is $5,398MM. To calculate the horizon value we first need to make an
assumption about the rate of growth in the cash flows beyond year five. Here, it is
always safe to be conservative, so we will use four percent (4%). Assuming that we
know the discount factor (as will be seen, it is the WACC) is 12.83%, the horizon value
would be calculated as follows:
HV5 = OFCF5(1+g)/(WACC g) = $5,398(1.04)/(.1283-.04) = $5,614/(.0883) = $63,546MM.
The $63,546 will become a net cash flow measured at the end of period five. Imagine it
as the price at which the firm will sell at that time. If you were investing in the firm
today, the $63,546MM would be the value youd expect to receive when you sell the
company in five years. Regardless of whether the company is sold, however, it is still
worth that much at the time.
The Discount Factor
The discount factor used to discount the operating free cash flows is the weightedaverage cost of capital. As you learned in Session 5, the WACC accounts for the different
types of debt and equity in the capital structure of the company. The weights are
determined by the amount of capital raised by each unit. These amounts are usually
obtained from the balance sheet, and therefore represent historical book values. The
freecashflow.xls spreadsheet has a sample calculation of the WACC, assuming that you
already know the values of the individual component costs of capital (e.g. such as the
cost of equity that results from the CAPM). The component costs here are assumed (made
up), so dont worry about where they came from. The amounts come from the 2002
balance sheet.
Weighted Average Cost of Capital
Calculation
Type of Capital
Note Payable
Long Term Debt
Common Equity
Total Capital
Amount
$950
$1,200
$12,688
$14,838
Weight
Component
Tax
(2)*(3)*(4)
Cost
Adjustment
6.40%
9.20%
0.60
0.35%
8.09%
10.50%
0.60
0.51%
85.51%
14.00%
1.00
11.97%
100.00%
WACC=
12.83%
There are two critical assumptions we implicitly make by using the WACC as a
discount factor. First, we assume that the component costs of capital are going to be the
same over the entire forecast horizon (which is infinite in this case!). Second, We assume
that the relative weights of each source of capital (note payable, long-term debt and
common equity) will remain the same over the forecast horizon. While these are
somewhat restrictive, we will make do for now and show what happens when things are
allowed to change at a later time.
Discounting to Determine Value
Once we have completed the calculation of the operating free cash flows for the
forecast period (in this case, five years), the horizon value, and the WACC, we are ready
to measure market value. To do this we simply discount the net cash flows as follows:
Corporate Valuation Using Free Cash
Flows and WACC
Year
Operating Free Cash Flow
Horizon Value
Total Free Cash Flow
WACC
Present (Market) Value @ WACC
2002
2003E
$4,273
2004E
$4,658
2005E
$4,987
2006E
$5,123
$4,273
$4,658
$4,987
$5,123
12.83%
$51,774
$950
$1,200
$12,688
$14,838
$36,936
Note that the horizon value is included as a cash flow to be discounted in year five
(2007E). The present value of the total free cash flows discounted at 12.83% is
$51,774MM as of 2002. This is the market value of the company (this can also be
referred to as the market value of the assets, as this company has no non-operating
assets).
The market value added by managing the assets is $36,936. It is obtained by
subtracting the book value of the capital from the market value of the assets, as can be
seen above.
What you should do now is go through the textbook reading for this session
(Chapter 12) and reconcile what you find there to the material in this presentation. A
discussion problem will be posted to give you practice in making this calculation.
2007E
$5,398
$63,546
$68,944