Assignment 4 controllership

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Valuation: Cash-Flow-Based

Approaches

Chapter: 12 2

Valuing the Firm Economic theory teaches us that the value of an

investment is:

Expected future payoffs can be measured in terms of:  Dividends  Cash Flows  Earnings

∑ = +

= n

t t

tV 1

0 Rate) Discount(1 Payoffs Future Projected

Chapter: 12 3

Approaches to firm valuation

Chapter: 12 4

Focus is on the cash that flows into the firm. Measures the cash flows that are “free” to

be distributed to shareholders. Cash flows generated by the firm create

dividend-paying capacity.

Cash-Flow-Based Valuation

Chapter: 12 5

Amount of cash flowing into firm differs from dividends paid in a particular period. But over the lifetime of the firm, cash

flows into and cash flows out of the firm will be equal.

Cash-Flow-Based Valuation (Contd.)

Chapter: 12 6

 Cash is the ultimate source of value. The free cash flows approach measures value based on the cash flows that the firm generates that can be distributed to investors. It is a measurable common denominator

for comparing the future benefits of alternative investment instruments.

Rationale for Using Free-Cash-Flows

Chapter: 12 7

Cost of Common Equity Capital CAPM Model:

portfolio marketwide on return Required j firm for beta Market

return of rate free-Risk j firm inequity common on return Required

nexpectatio :Where

= = = = =

×+=

M

j

F

Ej

FMjFEj

R ß R R E

]}]–E[R{E[Rß]E[R]E[R

Chapter: 12 8

Weighted Average Cost of Capital

costs debt to applicable rate is rateTax capital of type each of proportion isw

capital of type each of cost is R

:Where 1

1

=++

×+×+××=

EPD

EEPPDDA

www

]R[w]R[w]–tax rate)(R[wR

Chapter: 12 9

Measuring Free Cash Flows Under U.S. GAAP and IFRS, Cash flow

statement categorize the activities as operating, investing and financing. Some rearrangements are necessary to

compute free cash flows.

Chapter: 12 10

Measuring Free Cash Flows (Contd.)  Cash flow from operations from the

projected statement of cash flows is the most direct starting point because it requires the fewest adjustments.

 However, some analysts compute free cash flows using alternative starting points.

Chapter: 12 11

 Free Cash Flows for All Debt and Equity Stakeholders:

Operating Activities: Cash Flow from Operations +/- Net Interest after Tax +/- Changes in Cash Requirements for Liquidity = Free Cash Flows from Operations for All Debt and Equity

Investing Activities: +/- Net Capital Expenditures = Free Cash Flows for All Debt and Equity Stakeholders

Measuring Free Cash Flows

Chapter: 12 12

 Free Cash Flows for Common Equity Shareholders: Operating Activities: Cash Flow from Operations +/- Changes in Cash Requirements for Liquidity = Free Cash Flows from Operations for Equity

Investing Activities: +/- Net Capital Expenditures

Financing Activities: +/- Debt Cash Flows +/- Financial Asset Cash Flows +/- Preferred Stock Cash Flows = Free Cash Flows for Common Equity Stakeholders

Measuring Free Cash Flows

Chapter: 12 13

Cash-Flows-Based Valuation Models To value common equity measure: Discount rate – RE . Expected future free cash flows – FCFEq for

periods 1 through T over forecast horizon. Continuing free cash flows, FCFEq(T+1), and

long-run growth rate, g.

Chapter: 12 14

For common equity shareholders:

rate Growth capitalequity on return of rate Required

rsshareholdeequity common for flows cash Free firm a ofequity common the of value Present

Where,

= = = =

+××+ 

  

 +

= ∑ =

+

g R FCFE

V

])R/([–g)]/(R[][FCFE )R(

FCFE V

E

T

t

T EETt

E

t

0

1 10 1111

Free-Cash-Flows-Based Valuation Models

Chapter: 12 15

Free-Cash-Flows-Based Valuation Models  For all debt and equity capital stakeholders:

rate Growth capital of cost average weightedfuture Expected

rsstakeholde capitalequity and debt all for flows cash Free

firm a of assets operating net of value Present Where,

= =

= =

+××+ 

  

 +

= ∑ =

+

g R

FCFA VNOA

])R/([–g)]/(R[][FCFA )R(

FCFA VNOA

A

T

t

T AATt

A

t

0

1 10 1111

Chapter: 12 16

Continuing Value  Represented by last term of equation:

 Use expected long-term growth rate, g, to project all items on Year T+1 income statement and balance sheet. RA must be greater than g for this formula

to work.

])R/([–g)]/(R[][FCFA TAAT +××+ 1111

Chapter: 12 17

What now? Once valuation model is applied, then Conduct sensitivity analysis: Vary cost of equity capital rate (RE) Vary long-run growth rate (g) Discount rate assumptions Vary these parameters and assumptions

individually and jointly.

Chapter: 12 18

Evaluation of the Free-Cash-Flows- Valuation method Advantages:  Focuses on free cash flows, believed to

have more economic meaning than earnings.

 Results from projections of future operating, investing, and financing decisions of a firm made by the analyst.

Chapter: 12 19

Evaluation of the Free-Cash-Flows- Valuation method Advantages: (Contd.)  Focuses directly on net cash inflows

available to be distributed to capital providers. This perspective is especially pertinent to acquisition decisions.

 Widely used in practice.

Chapter: 12 20

Evaluation of the Free-Cash-Flows- Valuation method Disadvantages:  Can be time-consuming making it costly.  Continuing value tends to dominate the

total value but is sensitive to assumptions growth rates and discount rates.

 Free cash flow computations must be internally consistent with long-run assumptions regarding growth and payout. And is affected by estimation errors.