Chapter 4 - Free Cash Flow Valuation

Using the WACC and single stage FCFF Model to Value the Firm and Common Stock
Example for Slides 6-8

ASSUMPTIONS

Current FCFF
Target debt to capital
Market value of debt
Shares outstanding
Required return on equity
Cost of debt
Long-term growth in FCFF
Tax rate

$6,000,000
0.25
$30,000,000
2,900,000
12.0%
7.0%
5.0%
30%

OUTPUT - WACC, Value of firm and common stock

Calculation of WACC
After-tax cost of debt
WACC

4.90%
10.23%

Value of the firm

120,458,891

Value of equity
Per share value

$
$

90,458,891
31.19

mon Stock

Target D/E
Actual D/E
25.00%
24.90% these should probably not be too different (but note WACC is based on target values s

o different (but note WACC is based on target values so can be a slightly different)

Chapter 4 - Free Cash Flow Valuation

Determining FCFF and FCFE
Example for Slides 15-20
ASSUMPTIONS
EBITDA
Depreciation expense
Interest expense
Tax rate
Purchases of fixed assets
Change in working capital
Net borrowing
Common dividends

$1,000
$400
$150
30%
$500
$50
$80
$200

OUTPUT - FCFF from net income

Net Income
Depreciation expense
Interest expense(1-tax rate)
FCInv
WCInv
FCFF

$315
$400
$105
-$500
-$50
$270

OUTPUT - FCFF from EBIT

EBIT(1-tax rate)
Depreciation expense
FCInv
WCInv
FCFF

$420
$400
-$500
-$50
$270

OUTPUT - FCFF from EBITDA

EBITDA(1-tax rate)
Depreciation expense(Tax rate)
FCInv
WCInv
FCFF

$700
$120
-$500
-$50
$270

OUTPUT - FCFF from CFO

CFO
Interest expense(1-tax rate)
FCInv
FCFF

$665
$105
-$500
$270

OUTPUT - FCFE from FCFF

FCFF
Interest expense(1-tax rate)
Net borrowing
FCFE

$270
-$105
$80
$245

OUTPUT - FCFE from net income

Net Income
Depreciation expense
FCInv
WCInv
Net borrowing
FCFE

$315
$400
-$500
-$50
$80
$245

OUTPUT - FCFE from CFO

CFO
FCInv
Net borrowing
FCFE

$665
-$500
$80
$245

OUTPUT - FCFF from uses

Change in cash balance
Interest expense(1-tax rate)
Net borrowing
Common dividends
FCFF

$45
$105
-$80
$200
$270

OUTPUT - FCFE from uses

Change in cash balance
Common dividends
FCFE

$45
$200
$245

Chapter 4 - Free Cash Flow Valuation

Forecasting FCFF and FCFE
Example for Slides 22-25
ASSUMPTIONS
Sales
Sales growth
EBIT
Tax rate
Purchases of fixed assets
Depreciation expense
Change in working capital
Net Income margin
Debt Ratio

$4,000
$200
$600
30%
$800
$700
$50
10%
40%

OUTPUT - Fundamental relationships

Sales growth in percent
EBIT margin
Incremental capital expenditures/sales growth
Incremental working capital investments/sales growth

5.00%
15.00%
50.00%
25.00%

OUTPUT - Forecasts of next year's financials and FCFF

Next Year Forecasts
Sales
EBIT
EBIT(1-tax rate)
Incremental FC
Incremental WC
FCFF

$4,200.00
$630.00
$441.00
-$100.00
-$50.00
$291.00

OUTPUT - Forecasts of next year's financials and FCFE

Net Income
Incremental FC
Incremental WC
Net borrowing
FCFE

$420.00
-$100.00
-$50.00
$60.00
$330.00

Chapter 4 - Free Cash Flow Valuation

Two-stage model with constant growth rate in each stage FCFE is derived from sales (assumes that 1st stage
Example for Slides 28-31
ASSUMPTIONS
Current Sales per share
Sales growth for 1st 3 years
Sales growth for year 4 and thereafter
Net Income margin
FCInv/Sales growth
WCInv/Sales growth
Debt financing of FCInv and WCInv growth
Required return on equity

$10
20%
5%
10%
40%
25%
30%
12.00%

OUTPUT - Future FCFE

Year
1
20%
$12.000
$1.200
$0.800
$0.500
$0.390
$0.290

Sales growth in percent

Sales per share
EPS
FCInv per share
WCInv per share
Debt financing per share
FCFE per share
Growth in FCFE
OUTPUT - PV of future FCFE & Equity value
PV of FCFE during 1st stage
PV of perpetual stream FCFE at t=3
PV of perpetual stream FCFE at t=0
Equity value

0.259 $

$15.29

2
20%
$14.400
$1.440
$0.960
$0.600
$0.468
$0.348
20.0%

0.277

from sales (assumes that 1st stage lasts 3 years)

Year
3
20%
$17.280
$1.728
$1.152
$0.720
$0.562
$0.418
20.0%

4
5%
$18.144
$1.814
$0.346
$0.216
$0.168
$1.421
240.3%

0.297
$20.30
$14.45

5
5%
$19.051
$1.905
$0.363
$0.227
$0.177
$1.492
5.0%

5.5%

of total stock value

94.5%

of total stock value

Chapter 4 - Free Cash Flow Valuation

Two-stage model where growth gradually drops from stage 1 to stage 2
Example for Slides 33-38
ASSUMPTIONS
Current EPS
WCInv/FCInv
Debt financing of FCInv and WCInv growth
Required return on equity
EPS and FCInv growth for year 5 and thereafter

FCFE is derived from EPS (assumes

$1.00
40%
30%
12.00%
5%
Year
1
30%
$1.50

EPS growth
FCInv

2
21%
$1.25

OUTPUT - Future FCFE

Year
1
$1.300
$1.500
$0.600
$0.630
-$0.170

EPS
FCInv per share
WCInv per share
Debt financing per share
FCFE per share
OUTPUT - PV of future FCFE & Equity value
PV of FCFE during 1st stage
PV of perpetual stream FCFE at t=4
PV of perpetual stream FCFE at t=0
Equity value

OUTPUT - Trailing P/E (assumes Value=Price)

Trailing P/E in year 0 and year 4

(0.152) $

$15.30

15.3

2
$1.573
$1.250
$0.500
$0.525
$0.348

0.277

derived from EPS (assumes that 1st stage lasts 4 years)

Year
3
13%
$1.00

4
8%
$0.75

5
5%
$0.50

Year
3
$1.777
$1.000
$0.400
$0.420
$0.797

4
$1.920
$0.750
$0.300
$0.315
$1.185

5
$2.016
$0.500
$0.200
$0.210
$1.526

0.568

0.753
$21.80
$13.85

11.4

9.5%

of total stock value

90.5%

of total stock value

Chapter 4 - Free Cash Flow Valuation

Three-stage model where growth gradually drops in stage 2
Example for Slides 39-42
ASSUMPTIONS
Current FCFF in millions
Shares outstanding in millions
Long-term debt value in millions
FCFF growth for years 1 to 3
FCFF growth for year 4
FCFF growth for year 5
FCFF growth for year 6 and thereafter
WACC

(assumes that 1st stage lasts 3 years)

$100.00
300.00
$400.00
30.00%
24%
12%
5%
10.00%

OUTPUT - FCFF, firm & equity value

FCFF growth rate
FCFF
PV of FCFF

1
30%
$130.0
$118.2

PV of perpetual stream FCFF at t=5

PV of perpetual stream FCFF at t=0
Firm value

$4,777.0

Equity value

$4,377.0

Equity value per share

$14.59

2
30%
$169.0
$139.7

Year
3
30%
$219.7
$165.1

lasts 3 years)

Year
4
24%
$272.4
$186.1

5
12%
$305.1
$189.5
$6,408
$3,979

6
5%
$320.4