Mod-4-CashFlowModel.pdf

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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.

Slide Number 1
Valuing the Firm
Approaches to firm valuation
Slide Number 4
Slide Number 5
Slide Number 6
Cost of Common Equity Capital
Weighted Average Cost of Capital
Measuring Free Cash Flows
Measuring Free Cash Flows (Contd.)
Measuring Free Cash Flows
Measuring Free Cash Flows
Cash-Flows-Based Valuation Models
Free-Cash-Flows-Based Valuation Models
Free-Cash-Flows-Based Valuation Models
Continuing Value
What now?
Evaluation of the Free-Cash-Flows-Valuation method
Evaluation of the Free-Cash-Flows-Valuation method
Evaluation of the Free-Cash-Flows-Valuation method