SUGGESTED SOLUTION

1)INCOME STATEMENT METHOD

2015 2016 2017
Operating Profit 1 27 090 27 500 28 590
Depreciation 2 26 280 26 940 27 480
Movement in provisions 2 500 100 160
Interest Income 3 580 410 420
Taxes Paid 4 -1 730 -6 310 -6 720
Inventories 5 1 450 -2 870 -480
Biological Assets 5 -160 -710 -1 100
Trade Receivables 5 -1 760 -820 -1 250
Trade Payables 5 850 620 940
Capital Expenditure 6 -30 730 -30 530 -32 970
179 630 – (175 180 – 26 280)*
*Use a T-account
Free Cash Flows 22 370 14 330 15 070

Explanation

1) It is possible to start the income statement method either beginning from revenue or even later
from Earnings before tax or Net Income so long as the correct adjustments are made (e.g. add back
depreciation, add back interest). Remember your bucket method: things that are in the bucket and
should not be there need to be taken out. Things that are not in the bucket and should not be there
are left out the bucket. Finally, things that are not in the bucket and should be there should be put in
the bucket. It is important to plan and see what the most effective way (least adjustments) would be
in order to determine FCF as an unnecessary long route will take up precious time in an exam.

2) As we are doing a free cash flow valuation, any amounts included in profit before tax, which are
not cash items need to be reversed when doing the valuation. Therefore depreciation and
movement in provisions (which would have both been expensed) are added back. It is worth your
while to consider the essence of the provision as it may be necessary to include a maintainable
amount in the representative year. A provision does represent a possible future cash outflow.

3) We add interest income in because our starting point was operating profit which is before interest
income. In this example we did not value interest income separately as it resulted from normal
working capital/operating activities. If the interest received was on excess cash invested, it would
have been valued separately and not included in the main valuation. This income is a normal activity
of the business as indicated in the information.

Interest Expense

We do NOT include interest expense because remember that ‘Free Cash Flow’ is actually ‘Free Cash
Flow available for distribution to all providers of permanent capital included in the WACC’ (should
not be in the bucket, and is not in the bucket, therefore leave it out). If we had started from net
profit, then we would add it back (should not be in the bucket, and is in the bucket, therefore take it
out by adding it back)

4) Remember we need tax actually paid (cash tax) and therefore this amount is not the amount in
the Statement of Comprehensive Income, but rather the amount from the Statement of Cash Flows.
The adjustment to Interest expense wasn’t made in this example. One could have brought this
SUGGESTED SOLUTION

adjustment in as the tax benefit of interest expense is reflected in WACC. One could argue that the
tax benefit on debt is now counted for twice.

5) These are all considered to be working capital of CC. Therefore we need to make the ‘working
capital adjustment’ to move from the accrual basis to a cash basis. For example, receivables have
increased by R 1760 and therefore we reverse this by subtracting this amount, the reason is that if
receivables increase it means that the cash has not yet been received and therefore must be
excluded (subtracted) from free cash flow as these amount would have been included in the income
statement on the accrual basis.

6) This amount is from the Statement of Cash Flows and is the ‘expansion cost’ that CC will incur in
order to grow the business. When forecast statements are provided, it should be assumed (unless
stated otherwise) that the costs to maintain the business have already been taken into account
under operating expenses. (e.g.: maintenance costs). In conclusion when a forecasted income
statement and balance sheet are given, the cash flows associated with maintaining and growing
assets are included in these forecasts. In this example we got the movement from the cash flow
statement regarding expansion – this can also be obtained from the balance sheet movement with
regard to fixed assets.

2) BALANCE SHEET METHOD

2015 2016 2017
Cash Movement 1 -4 260 210 -760
Dividends 2 3 740 4 100 4 400
Repayment of interest-earning borrowings 2 16 000 4 890 6 830
2015 : (52 500 – 35 000 = 17 500) +
(10 170 – 11 670 = - 1 500)
Interest Expense 2 6 890 5 130 4 600
Free Cash Flows 22 370 14 330 15 070

Explanation

1) A free cash flow valuation requires the net free cash flow generated in each year. The movement
in cash and cash equivalents would represent the cash generated in each year, and would be the
starting point for any Free Cash Flow Valuation done under the balance sheet method. Using this as
a starting point one needs to take into account that all activities/transactions which has a cash flow
effect is now included in this balance, thus a few adjustments needs to be made to remove items we
don’t take into account in a FCF valuation.

2) The free cash flow valuation is based on cash available to all providers of capital. Dividends
represent cash available to shareholders and should thus not be deducted from FCF. Dividends paid
would have reduced cash flow (our starting point). Therefore it is reversed by adding it back as it was
originally subtracted from the bank balance. Similarly, the repayment of interest earning borrowings
would be a payment to a capital provider and it should be reversed by adding it back as it has
already been deducted from the bank balance. Finally, the interest expense would also need to be
added back as it has been subtracted from the bank balance and as explained we need the cash
available to all providers of capital.
SUGGESTED SOLUTION

3) CASH FLOW STATEMENT METHOD

2015 2016 2017
Cash flows from operating activities
Cash generated from operations 54 830 51 170 54 760
Interest paid 1 0 0 0
Dividends paid 1 0 0 0
Income taxes paid 2 -1 730 -6 310 -6 720
Cash flows from investing activities
Additions to Property, plant and 3 -30 730 -30 530 -32 970
equipment
Free Cash Flows 22 370 14 330 15 070

Explanation

Remember for the cash flow statement method, the most important section of the statement of
cash flows is cash flows from operating activities as these make up the core operations of the entity,
and essentially drive the value of the entity, and hence are included (of course, interest and
dividends will not be included for reasons stated). Certain cash flows from investing activities will
need to be included (e.g. additions to PPE) but non-operating activities (e.g. acquisition of listed
shares) are not related to the core activities of the entity and are therefore not included (we would
however value these investments separately and add to the end). Finally, financing activities will not
add value to the business and hence any issue/repurchase of equity or receipt/payment of a loan
will not be included in the valuation.

1) Interest and dividends paid are not deducted because we are looking for the ‘free cash flow
available for distribution to all providers of capital.’ (Should not be in the bucket, are not in the
bucket, therefore leave them out) – Starting point – cash generated from operating activities.

2) This is the cash tax (as explained above in note 4 of the Income Statement method)

3) As explained this amount is from the Statement of Cash Flows and is the ‘expansion cost’ that CC
will use in order to grow the business. When forecast statements are provided, it can be assumed
(unless stated otherwise) that the costs to maintain the business have already been taken into
account under operating expenses. (e.g.: maintenance costs)