Cash flow modeling

CFV600 CORPORATE FINANCE AND EQUITY VALUATION

FALL SEMESTER 2022, NICLAS ANDRÉN

 Models for discounted cash flow valuation
• Dividend-discount model (DDM)
Cash flow = dividends to common shareholders + share repurchases – share issues
Pinto suggests Cash flow = dividends to common shareholders, which is reasonable if share
repurchases are made at market prices
Cost of capital = cost of equity

• Free-cash-flow-to-equity (potential dividend) model (FCFE)

Cash flow = cash flow available for dividends (after financial cash flows)
Cost of capital = cost of equity

• Free cash-flow-to-firm model (FCFF)

Cash flow = operating cash flow
Cost of capital = WACC
 DDM
Generally, the definition of returns as dividends, and the DDM, is most suitable when:
• the company is dividend-paying (i.e., the analyst has a dividend record to analyze);
• the board of directors has established a dividend policy that bears an understandable and consistent
relationship to the company’s profitability; and
• the investor takes a non-control perspective

Example 4, Ch 7

Terminal value
(here, we typically use a perpetuity
model instead of specifying a TV)
 Empirical patterns in dividend payments
Brav, Graham, Harvey, and Michaely (2005)
• Dividends as prioritized as investments
– Many managers prefer to pass up profitable investments rather than cut dividends
• External funds would rather be raised before cutting dividends
• Dividend policies are conservative
– Many managers exhibit strong aversion against cutting dividends
• Dividends are smoothed from year to year
• Dividends are paid by mature firms (cash cows)
• Dividends are tied to long-term sustainable earnings

Bulan and Hall (2013)

• Managers very reluctant to cut dividends
• Managers do not cut dividends until forced to do so by the creditors
 Empirical patterns in repurchases
Brav, Graham, Harvey, and Michaely (2005)
• Repurchase decision subordinated to investment decisions
• Repurchases considered more flexible than dividends
– Time the market
– Repurchase when you have free cash flow and too much cash
• Repurchase to reduce the stock’s free float
• Repurchase to reissue in employee stock options without any ownership dilution
• Repurchase stock to use as payment in acquisitions
 Consequences of the empirical patterns for DDM
Dividends
• Conservative dividends mean that dividends will lag the firm’s cash flows, possibly by
many years, meaning DDM will underestimate firm value

Repurchases
• Repurchases will be difficult to predict
– Occurring when management believes the market to undervalue the shares
– Occurring when the firm is expected to have free cash flow
– Occurring in chunks (through tender offers) when the firm has too much cash
• This means repurchases will lag the firm’s cash flows, possibly by many years,
meaning DDM will underestimate firm value

Equity issues
• Equity issues are the “lender of last resort” for many firms
– They are sometimes common in the early years for small firms
– Other than that, they primarily occur when the firm is in financial difficulty
– Firms may also issue equity through stock-based compensation programs and in acquisitions
• This means equity issues will be near-impossible to predict
FCFF and FCFE
Generally, the FCFE and FCFF models are most suitable when:
• the company is not dividend-paying;
• the company is dividend-paying, but dividends significantly exceed or fall short of FCFE;
• dividends and repurchases are untimely indicators of the firm’s expected value creation
and cash flows
• the company’s free cash flows align with the company’s profitability within a forecast
horizon with which the analyst is comfortable; and
• the investor takes a control perspective.
When should DCF models yield the same result?
FCFE and FCFF always yield same result if you do your calculations correctly
1. Consistent assumptions between the different models
2. Interest-bearing debt is priced correctly (interest expense should be at rD)

DDM and FCFE yield the same result if

1. Payout ratio = 1, or
2. Retained cash (FCFE – dividends) are invested to yield NPV = 0
→ Theoretically even if NPV > 0, since retained cash then should
lead to a corresponding increase in expected future dividends
FCFF vs FCFE
I prefer FCFF because…
1. Clearer connection to the firm’s value drivers
2. No need to forecast financial cash flows
3. Easy to incorporate changing capital structures
4. Easy to disaggregate to units within the firm
5. Avoids problems with negative FCFE (more common than negative FCFF)

Common critique against FCFF (and defense of FCFE):

1. FCFE more intuitive cash flow measure from owner viewpoint
2. FCFF may blind you to the importance of financing cash flows
(you uncritically work with WACC)
3. FCFF may oversimplify capital structure forecasting
Calculating FCFF
• Calculating FCFF from the cash flow from operations

FCFF = Cash flow from operations

+ Interest expense×(1 – Tax rate)
– Investment in fixed capital

Example
• Cash flow from operations = 86.52 Example 3, ch 8

• Debt = 224
• Interest rate = 7%
• Tax rate = 30%
• Investment in fixed capital = 0

• FCFF = ?
Calculating FCFF
• Calculating FCFF from net income

FCFF = Net income available to common shareholders (NI)

+ Net noncash charges (NCC)
+ Interest expense×(1 – Tax rate)
– Investment in fixed capital (FCInv)
– Investment in working capital (WCInv)

Example Example 2, ch 8

• Net income = 97.52

• Net noncash charges = 45
• Interest expense after taxes = 10.98
• Investment in fixed capital = 0
• Investment in working capital = 56

• FCFF = ?
 Example 2, Ch 8: Calculating FCFF from net income

FCFF = Net income available to common shareholders (NI)

+ Net noncash charges (NCC)
+ Interest expense×(1 – Tax rate)
– Investment in fixed capital (FCInv)
– Investment in working capital (WCInv)
 Example 2, Ch 8: Calculating FCFF from net income

FCFF = Net income available to common shareholders (NI)

+ Net noncash charges (NCC)
+ Interest expense×(1 – Tax rate)
– Investment in fixed capital (FCInv)
– Investment in working capital (WCInv)
 Example 2, Ch 8: Calculating FCFF from net income

FCFF = Net income available to common shareholders (NI)

+ Net noncash charges (NCC)
+ Interest expense×(1 – Tax rate)
– Investment in fixed capital (FCInv)
– Investment in working capital (WCInv)
Example 3, Ch 8: Calculating FCFF from CFO
FCFF = Cash flow form operations
+ Interest expense×(1 – Tax rate)
– Investment in fixed capital

From Ex2
Calculating FCFF from operating income
• Calculating FCFF from operating income
FCFF = Operating income ×(1 – Tax rate)
+ Net noncash charges
– Investment in fixed capital
– Investment in working capital

• Operating income:
Operating income = Revenues – Operating expenses
Operating income after taxes = (Revenues – Operating expenses)×(1 – Tax rate)

• NOPAT = Operating income after taxes

– Net operating profit after taxes
 Example 2, Ch 8: Calculating FCFF from operating
income

NOPAT = Operating income ×(1 – Tax rate) Years ending December 31

+ Depreciation expense 2010 2011 2012
– Investment in fixed capital (FCInv) NOPAT $108.50 $119.35 $131.29
– Investment in working capital (WCInv)
Noncash charges – Depreciation 45.00 49.50 54.45
= FCFF
Investment in fixed capital (0.00) (50.00) (55.00)

Investment in working capital (56.00) (11.60) (12.76)

Free cash flow to the firm $97.50 $107.25 $117.98

Dependence on cash flow statement
• A weakness of the way we have approached FCFF so far is that we need to forecast
the CF statement
Net noncash charges
Net noncash charges – BMW’s cash flow statement

Net noncash charges

CFO

Your task: calculate net noncash charges

Dependence on cash flow statement
• A weakness of the way we have approached FCFF so far is that we need to forecast
the CF statement
– Net noncash charges

• A benefit is that the calculation of FCInv and WCInv is straightforward

– But if FCInv and WCInv from the cash flow statement differ from the change in asset and
liability values on the balance sheet, then forecasting FCInv and WCInv may be difficult
 WCInv – BMW’s cash flow statement

WCInv

CFO

Your task: calculate Investment in working capital

Calculating FCFF – BMW’s cash flow statement –
investment and financing cash flows

FCInv

Your task: calculate Investment in fixed capital

Dependence on cash flow statement
• A weakness of the way we have approached FCFF so far is that we need to forecast
the CF statement
– Net noncash charges

• A benefit is that the calculation of FCInv and WCInv is straightforward

– But if FCInv and WCInv from the cash flow statement differ from the change in asset and
liability values on the balance sheet, then forecasting FCInv and WCInv may be difficult

• The alternative: work with income statement and balance sheet

– Cash flow statement is a derivative statement, being derived from I/S and B/S
– All noncash charges are also reported on I/S and B/S

• Example: depreciation
Fixed capital
• B/S reports asset values net of depreciation/amortization

Gross value Net value

FCFF and gross vs net investment in FC
• Fixed capital:
Fixed capital (gross) = Gross property, plant, and equipment + Other (gross) operating
noncurrent assets – Noncurrent operating provisions and liabilities
FCInv (gross) = Fixed capital (gross)t+1 – Fixed capital (gross)t

Fixed capital (net) = Net property, plant, and equipment + Other (net) operating noncurrent
assets – Noncurrent operating provisions and liabilities
FCInv (net) = Fixed capital (net)t+1 – Fixed capital (net)t
FCInv (gross) = Fixed capital (net)t+1 + Net noncash chargest+1 – Fixed capital (net)t

• Consistency between I/S and B/S

FCFF = NOPAT + Net noncash charges – FCInv (gross) – WCInv
FCFF = NOPAT – FCInv (net) – WCInv
Invested capital
• Invested capital (IC)

Invested capital = Working capital + Fixed capital (net)

ICInv (gross) = Invested capitalt+1 + Net noncash chargest+1 – Invested capitalt
ICInv (net) = Invested capitalt+1 – Invested capitalt
ICInv (net) = Net investment

• FCFF

FCFF = NOPAT – ICInv (net)

 Example 2, Ch 8: Calculating invested capital

Years ending December 31

2009 2010 2011 2012

Fixed capital (gross) $500.00 $500.00 $550.00 $605.00

Accumulated depreciation (0.00) (45.00) (94.50) (148.95)

Invested capital = Working capital + Fixed capital (net)
Fixed capital (net) 500.00 455.00 455.50 456.05

Fixed capital (net) = Net property, plant, and equipment + Working capital 60.00 116.00 127.60 140.36
Other (net) operating noncurrent assets – Noncurrent Invested capital 560.00 571.00 583.10 596.41
operating provisions and liabilities
Net investment in invested capital $11.00 $12.10 $13.31
 Example 2, Ch 8: Calculating FCFF from NOPAT
Years ending December 31 Years ending December 31

2010 2011 2012 2009 2010 2011 2012

NOPAT $108.50 $119.35 $131.29 Fixed capital (gross) $500.00 $500.00 $550.00 $605.00

Noncash charges – Depreciation 45.00 49.50 54.45 Accumulated depreciation (0.00) (45.00) (94.50) (148.95)

Investment in fixed capital (0.00) (50.00) (55.00) Fixed capital (net) 500.00 505.00 455.50 456.05

Investment in working capital (56.00) (11.60) (12.76) Working capital 60.00 116.00 127.60 140.36

Free cash flow to the firm $97.50 $107.25 $117.98 Invested capital 560.00 571.00 583.10 596.41

Net investment in invested capital $11.00 $12.10 $13.31

Years ending December 31

2010 2011 2012

NOPAT $108.50 $119.35 $131.29

Net investment in invested capital (11.00) (12.10) (13.31)

Free cash flow to the firm $97.50 $107.25 $117.98

Principles for reformulating the balance sheet
Invested capital = Funds invested
Operating assets Financial obligations, incl minority equity
– Operating liabilities Shareholders’ (common) equity
– Net non-operating assets

What are operating assets and liabilities?

• What the firm is in the business of doing

Matching principle
• Match operating assets and liabilities with their corresponding incomes and expenses
– If you classify an asset as operating, include related incomes/expenses in NOPAT
• All assets that are classified as operating are valued through FCF
– Non-operating assets have to be valued separately
Examples of non-operating items
• Financial liabilities – included in WACC
• Financial assets – typically, you use their B/S (fair) values
• Underutilized (passive/slack) assets that don’t generate NOPAT (or are utilized inefficiently)
• Holdings in other businesses
Fixed capital
• Fixed capital:
Fixed capital (gross) = Gross property, plant, and equipment + Other (gross) operating
noncurrent assets – Noncurrent operating provisions and liabilities
Gross investment in fixed capital = Fixed capital (gross)t+1 – Fixed capital (gross)t

• B/S reports asset values net of depreciation/amortization

Working capital
• Working capital:
Working capital = Operating current assets – Operating current liabilities
Operating current assets = Current assets – Cash and marketable securities
Operating current liabilities = Current liabilities – Short-term adjusted debt
Investment in working capital = Working capitalt+1 – Working capitalt
Calculating FCFE
PV(FCFF) FCFF
– Value of financial obligations – Interest expense after tax
= PV(FCFE) – Repayment of debt
+ New debt raised
= FCFE
 DCF example – set up I/S and B/S for 2021 and
calculate NOPAT, Net investment, and FCFF
Summary income statement 2020A Summary balance sheet 2020A
Revenue 788 Current assets 143
Cost of goods sold -425 Fixed assets 1159
Gross profit 363 Total assets 1302
General and administrative expenses -162
Operating income 201 Operating current liabilities 129
Operating non-current liabilities 37
Interest-bearing debt 703
Stockholders' equity 433
Liabilities and stockholders' equity 1302

Financial projections 2021E

Revenue growth 7,0%
COGS/Revenue 0,50
General and admin/Revenue 0,20
WC turnover 55,50
FC turnover 0,76
Tax rate 22%
Cost of capital 7,5%

WC turnover = Revenue/Working capital WC = Current operating assets – current operating liabilities

FC turnover = Revenue/Fixed capital FC = Non-current operating assets – non-current operating liabilities
DCF example – NOPAT
2020A 2021E
Revenue 788 843
- Cost of goods sold -425 -422
Gross profit 363 422
- General and admin expenses -162 -169
Operating income 201 253
- Operating taxes -56
NOPAT 197

• NOPAT = Net operating profit after taxes

– After-tax income generated from firm’s operations

Revenuen = Revenuen-1 × (1 + Revenue growth rate forecast)

Cost of goods soldn = Revenuen × (COGS/Revenue forecast)
General and administrative expensesn = Revenuen × (GA/Revenue forecast)
DCF example – IC
Summary balance sheet 2020A 2020A
Current assets 143 Current assets 143
Fixed assets 1159 - Current operating liabilities -129
Total assets 1302 Working capital 14

Operating current liabilities 129 Fixed assets 1 159

Operating non-current liabilities 37 - Non-current operating liabilities -37
Interest-bearing debt 703 Fixed capital (net) 1 122
Stockholders' equity 433
Liabilities and stockholders' equity 1302 Working capital 14
Fixed capital (net) 1 122
Invested capital 1 136

Interest-bearing debt 703

Stockholders' equity 433
Total funds invested 1 136

• IC = Invested capital
– Value of operating assets minus operating liabilities
DCF example – ICInv (net)
2020A 2021E
Current assets 143
- Current liabilities -129
Working capital 14 15

Fixed assets 1 159

- Non-current liabilities -37
Fixed capital 1 122 1 109

Working capital 14 15
Fixed capital 1 122 1 109
Invested capital 1 136 1 125

2019A 2020E
Invested capital 1 136 1 125
ICInv (net) -11

ICInv (net) = Net investment = Increase in IC from one year to another

WCn = Revenuen ÷ (Revenue/WC turnover forecast)
FCn = Revenuen ÷ (Revenue/FC turnover forecast)
 DCF example – FCFF
2020A 2021E
NOPAT 197
- ICInv (net) 11
FCFF 209

• FCFF = Free cash flow to firm = NOPAT – ICInv (net)

= Cash flow generated by the firm’s operations
 DCF example – let’s do the full valuation
Summary income statement 2020A Summary balance sheet 2020A
Revenue 788 Current assets 143
Cost of goods sold -425 Fixed assets 1159
Gross profit 363 Total assets 1302
General and administrative expenses -162
Operating income 201 Operating current liabilities 129
Operating non-current liabilities 37
Interest-bearing debt 703
Stockholders' equity 433
Liabilities and stockholders' equity 1302

Financial projections 2020A 2021E 2022E 2023E 2024E 2025E 2026E 2027E
Revenue growth 7,0% 7,0% 7,0% 7,0% 6,0% 5,0% 3,0%
COGS/Revenue 0,50 0,51 0,52 0,53 0,54 0,56 0,58
General and admin/Revenue 0,20 0,20 0,20 0,20 0,20 0,20 0,20
WC turnover 55,50 58,80 62,50 66,50 66,50 66,50 66,50
FC turnover 0,76 0,80 0,85 0,87 0,87 0,87 0,87
Tax rate 22% 22% 22% 22% 22% 22% 22%
Cost of capital 7,5% 7,5% 7,5% 7,5% 7,5% 7,5% 7,5%

WC turnover = Revenue/Working capital WC = Current operating assets – current operating liabilities

FC turnover = Revenue/Fixed capital FC = Non-current operating assets – non-current operating liabilities
DCF example – NOPAT
2020A 2021E 2022E 2023E 2024E 2025E 2026E 2027E
Revenue 788 843 902 965 1033 1095 1150 1184
- Cost of goods sold -425 -422 -460 -502 -547 -591 -644 -687
Gross profit 363 422 442 463 485 504 506 497
- General and admin expenses -162 -169 -180 -193 -207 -219 -230 -237
Operating income 201 253 262 270 279 285 276 261
- Operating taxes -56 -58 -59 -61 -63 -61 -57
NOPAT 197 204 211 218 222 215 203

• NOPAT = Net operating profit after taxes

– After-tax income generated from firm’s operations

Revenuen = Revenuen-1 × (1 + Revenue growth rate forecast)

Cost of goods soldn = Revenuen × (COGS/Revenue forecast)
General and administrative expensesn = Revenuen × (GA/Revenue forecast)
DCF example – ICInv (net)
2020A 2021E 2022E 2023E 2024E 2025E 2026E 2027E
Current assets 143
- Current liabilities -129
Working capital 14 15 15 15 16 16 17 18

Fixed assets 1 159

- Non-current liabilities -37
Fixed capital 1 122 1 109 1 128 1 136 1 187 1 258 1 321 1 361

Working capital 14 15 15 15 16 16 17 18
Fixed capital 1 122 1 109 1 128 1 136 1 187 1 258 1 321 1 361
Invested capital 1 136 1 125 1 143 1 151 1 203 1 275 1 339 1 379

2019A 2020E 2021E 2022E 2023E 2024E 2025E 2026E

Invested capital 1 136 1 125 1 143 1 151 1 203 1 275 1 339 1 379
ICInv (net) -11 18 8 52 72 64 40

ICInv (net) = Net investment = Increase in IC from one year to another

WCn = Revenuen ÷ (Revenue/WC turnover forecast)
FCn = Revenuen ÷ (Revenue/FC turnover forecast)
 DCF example – FCFF
2020A 2021E 2022E 2023E 2024E 2025E 2026E 2027E
NOPAT 197 204 211 218 222 215 203
- ICInv (net) 11 -18 -8 -52 -72 -64 -40
FCFF 209 186 203 166 150 151 163

• FCFF = Free cash flow to firm = NOPAT – ICInv (net)

= Cash flow generated by the firm’s operations
 DCF example – TV
2020A 2021E 2022E 2023E 2024E 2025E 2026E 2027E
NOPAT 197 204 211 218 222 215 203
- ICInv (net) 11 -18 -8 -52 -72 -64 -40
FCFF 209 186 203 166 150 151 163

𝐹𝐶𝐹𝐹𝑛+1
𝑇𝑉𝑛 =
𝑊𝐴𝐶𝐶 − 𝑔

• To calculate TV, we need to assume an eternal, stable growth rate

– Assume gTV = 3%

• FCFFn+1 = FCFF2028 = FCFF2027×(1 + g) = 163×1.03 = 168

– First year of TV forecast must grow at TV growth rate
– So should last year of explicit forecast period
• WACC = 7.5%
• TV2027 = 168 / (0.075 – 0.03) = 3,732
 DCF example – the valuation
2020A 2021E 2022E 2023E 2024E 2025E 2026E 2027E 2028E
FCFF 209 186 203 166 150 151 163
Terminal value 3732
PV(FCFF) 194 161 163 124 104 98 98
Sum PV(FCFF) 943 = 194+161+163+124+104+98+98
PV(Terminal value) 2249 = 3732/1.0757
Estimated firm value 3192

𝑇
𝐹𝐶𝐹𝐹𝑛 𝐹𝐶𝐹𝐹𝑇+1
𝐸𝑉 = ෍ 𝑛
+ 𝑇
1 + 𝑊𝐴𝐶𝐶 𝑊𝐴𝐶𝐶 − 𝑔 1 + 𝑊𝐴𝐶𝐶
𝑛=1

𝑇
𝐹𝐶𝐹𝐹𝑛 𝑇𝑉𝑇
𝐸𝑉 = ෍ 𝑛
+ 𝑇
1 + 𝑊𝐴𝐶𝐶 1 + 𝑊𝐴𝐶𝐶
𝑛=1

Estimated firm value 3192

+ Cash 0
- Debt - 703
Estimated equity value 2489
Residual income and Economic profit
• Return on invested capital (ROIC):

ROIC = NOPAT / Invested capital

• Economic profit (EP) – also called Economic value added (EVA):

Economic profit = Invested capital×(ROIC – WACC)

• Return on equity (ROE):

ROE = Net income / Shareholder’s equity

• Residual income (RI) (e g, Example 1, Ch 10 in Pinto):

Residual income = Shareholder’s equity×(ROE – rE)

DCF example – Finally, calculate economic profit

2020A 2021E
NOPAT 197
IC 1 136 1 125

WACC 7,50%

𝑁𝑂𝑃𝐴𝑇𝑛+1
𝑅𝑂𝐼𝐶𝑛+1 =
𝐼𝐶𝑛

𝐸𝑃𝑛+1 = 𝐼𝐶𝑛 𝑅𝑂𝐼𝐶𝑛+1 − 𝑊𝐴𝐶𝐶

DCF example – Economic profit

2020A 2021E 2022E 2023E 2024E 2025E 2026E 2027E

NOPAT 197 204 211 218 222 215 203
IC 1 136 1 125 1 143 1 151 1 203 1 275 1 339
ROIC 17,37% 18,15% 18,44% 18,90% 18,46% 16,88% 15,18%
WACC 7,50% 7,50% 7,50% 7,50% 7,50% 7,50% 7,50%
Economic profit (EP) 112 120 125 131 132 120 103

𝑁𝑂𝑃𝐴𝑇𝑛+1
𝑅𝑂𝐼𝐶𝑛+1 =
𝐼𝐶𝑛

𝐸𝑃𝑛+1 = 𝐼𝐶𝑛 𝑅𝑂𝐼𝐶𝑛+1 − 𝑊𝐴𝐶𝐶