Free-cashflows To Firms
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FREE-CASHFLOWS TO FIRMS
PROF. NAVEEN BHATIA
1
FREE CASH FLOW TO A FIRM FCFF= EBIT X (1-TAX RATE) +DEPN -CAPEX INCREASE IN WC FCFF= FCFE + INT X (1-TR) + PRINCIPAL REPAYMENTS- NEW DEBT ISSUES + PREFFEREFD DIVIDENDS. IMP. – FCFF DOESN’T CONSIDER ANY OF THE TAX BENEFITS DUETO
INTEREST PAYMENTS, WHICH IS ALREADY CONSIDERED IN COC AND INCLUDING THIS IN THE CASH FLOWS WOULD BE DOUBLE COUNTING IT.
EXPECTED GROWTH IN OP. INCOME= REINVESTMENT RATE * ROC RETURN ON CAPITAL=EBIT ( 1-T) DIVIDE BY ( BV OF DEBT + BV OF EQUITY) REINVESTMENT RATE= G/ROC
PROF. NAVEEN BHATIA
2
FREE CASH FLOW TO A FIRM
STABLE GROWTH FIRM:
VALUE OF FIRM= FCFF1/ ( WACC- gn) REINVESTMENT RATE= GROWTH RATE/ ROC GROWTH RATE<= NOMINAL GROWTH & IF REINVESTMENT IS ESTIMATED FROM THE NET CAPEX AND CHANGE IN WC , THEN LOOK AT THE INDUSTRY AVERAGES. THE BETA SHOULD BE CLOSE TO 1 ( BETWEEN 0.8 & 1.0) AGAIN IN THIS MODEL , FRIST WE DETERMINE THE VALUE OF OPERATING ASSETS. REMEMBER OP. EARNINGS DON’T INCLUDE THE EARNINGS FROM NON OPERATING ASSETS. TO THE VALUE OF OPERATING ASSETS SO OBTAINED ,WE ADD THE VALUE OF CASH & NON- OPERATING ASSETS AND SUBTRACT THE VALUE OF DEBT TO OBTAIN THE VALUE OF EQUITY.
PROF. NAVEEN BHATIA
3
FREE CASH FLOW TO A FIRM
MARKET VALUE WTS , CIRCULAR PROBLEMS AND COC:”
WE FIRST ESTIMATE THE VALUE BY USING THE CURRENT MPRICE TO DETERMINE THE WT. OF EQUITY. USING FCFF VLUATION , IF WE GET A LOWER INTINSIC VALUE, & WE USE THIS VALUE FOR DETERMINING THE WT OF EQUITY IN COC, WE WILL NOW GET A HIGHER INTRINSIC VALUE. THIS ITERATIVE PROCESS CAN GO ON TILL THE TWO VALUES ( IV AND THE VALUE USED TO DETERMINE THE WEIGHT) CONVERGE. FOR EXAMPLE IF YOU START WITH A MV OF 92.70 AND ESTIMATE THE IV AT 63.66 AND THEN USING ITERATIVE PROCESS, WE WILL ESTIMATE A VALUE OF 70.66 PER SHARE.
TWO –STAGE AND THREE- STAGE GROWTH MODEL:
SAME ASSUMPTIONS AND MODEL AS THAT FOR FCFE
PROF. NAVEEN BHATIA
4
FREE CASH FLOW TO A FIRM
FCFE VS FCFF:
THE VALUE FOR THE EQUITY OBTAINED FROM THE FIRM VALUATION EQUITY VALUATION WILL BE SAME IF ONE MAKES CONSISTEMNT ASSUMPTION ABOUT FINANCIAL LEVERAGES. A COST OF CAPITAL BASED ON MARKET VALUE WTS WILL NOT YIELD THE SAME VALUE FOR EQUITY AS AN EQUITY VALUATION MODEL IF THE FIRM IS NOT FAIRLY PRICED. THE INTEREST EXPENSES ARE EQUAL TO THE PRETAX COST OF DEBT MULTIPLIED BY MV OF DEBT. OF A FIRM HAS OLD DEBT ON ITS BOOKS, WITH INTEREST EXPENSES THAT ARE DIFFERENT FROM THIS VALUE, THE FCFE & FCFF APPROACH WILL DIVERGE.
PROF. NAVEEN BHATIA
5
FREE CASH FLOW TO A FIRM
EFFECT OF LEVERAGE ON A FIRMS VALUATION:
VALUE OF FIRM= SUM OF FCFF/ ( 1+WACC) IF WE ASSUME THAT FCFF ARE NOT AFFECTED BY THE CHOICE OF THE FINANCING MIX ( REMEMBER THEY ARE CASH FLOWS BEFORE INT ) AND THE COC REDUCES WITH THE INCREASING LEVERAGE THEN THE VALUE OF FIRM WILL INCREASE. THUS IF FCFF ARE UNAFFCTED BY LEVERAGE THE VALUE OF THE FIRM IS MAXIMISED BY MINIMISING THE COC. RECALL THAT BETA ( LEVERED) = B(UL) (1+(1-T)X D/E) THUS IF WE CAN ESTIMATE THE UNLEVERED BETA FOR A FIRM, WE CAN USE IT TO ESTIMATE THE LEVERED BETA OF A FIRM FOR EVERY DEBT RATIO. COST OF EQUITY= RFR + BETA ( LEVERED) ( RISK PREMIUM) THE COST OF DEBT FOR A FIRM IS A FUNCTION OF THE FIRM’S DEFAULT RISK. WE CAN NOW MEASURE THE FIRM’S WACC.
PROF. NAVEEN BHATIA
6
FREE CASH FLOW TO A FIRM
DEFAULT RISK, OPERATING INCOME & OPTIMAL LEVERAGE
THE OPERATING INCOME FOR MANY FIRMS WILL DROP AS THE DEFAULT RISK INCREASES. THE DROP IS LIKELY TO BE MORE PRONOUNCED AS THE DEFAULT RISK FALLS BELOW AN ACCEPTABLE LEVEL. FOR EXAMPLE , A BOND RATING BELOW INVESTMENT GRADE MAY TRIGER SIGNIFICANT LOSSES IN REVENUES AND INCREASE IN EXPENSES. IN SUCH A SCENARIO MAXIMISING A FIRMS VALUE REQUIRES LOOKING AT BOTH THE FIRMS CASH FLOWS AND THE WACC.
PROF. NAVEEN BHATIA
7
PROF. NAVEEN BHATIA
1
FREE CASH FLOW TO A FIRM FCFF= EBIT X (1-TAX RATE) +DEPN -CAPEX INCREASE IN WC FCFF= FCFE + INT X (1-TR) + PRINCIPAL REPAYMENTS- NEW DEBT ISSUES + PREFFEREFD DIVIDENDS. IMP. – FCFF DOESN’T CONSIDER ANY OF THE TAX BENEFITS DUETO
INTEREST PAYMENTS, WHICH IS ALREADY CONSIDERED IN COC AND INCLUDING THIS IN THE CASH FLOWS WOULD BE DOUBLE COUNTING IT.
EXPECTED GROWTH IN OP. INCOME= REINVESTMENT RATE * ROC RETURN ON CAPITAL=EBIT ( 1-T) DIVIDE BY ( BV OF DEBT + BV OF EQUITY) REINVESTMENT RATE= G/ROC
PROF. NAVEEN BHATIA
2
FREE CASH FLOW TO A FIRM
STABLE GROWTH FIRM:
VALUE OF FIRM= FCFF1/ ( WACC- gn) REINVESTMENT RATE= GROWTH RATE/ ROC GROWTH RATE<= NOMINAL GROWTH & IF REINVESTMENT IS ESTIMATED FROM THE NET CAPEX AND CHANGE IN WC , THEN LOOK AT THE INDUSTRY AVERAGES. THE BETA SHOULD BE CLOSE TO 1 ( BETWEEN 0.8 & 1.0) AGAIN IN THIS MODEL , FRIST WE DETERMINE THE VALUE OF OPERATING ASSETS. REMEMBER OP. EARNINGS DON’T INCLUDE THE EARNINGS FROM NON OPERATING ASSETS. TO THE VALUE OF OPERATING ASSETS SO OBTAINED ,WE ADD THE VALUE OF CASH & NON- OPERATING ASSETS AND SUBTRACT THE VALUE OF DEBT TO OBTAIN THE VALUE OF EQUITY.
PROF. NAVEEN BHATIA
3
FREE CASH FLOW TO A FIRM
MARKET VALUE WTS , CIRCULAR PROBLEMS AND COC:”
WE FIRST ESTIMATE THE VALUE BY USING THE CURRENT MPRICE TO DETERMINE THE WT. OF EQUITY. USING FCFF VLUATION , IF WE GET A LOWER INTINSIC VALUE, & WE USE THIS VALUE FOR DETERMINING THE WT OF EQUITY IN COC, WE WILL NOW GET A HIGHER INTRINSIC VALUE. THIS ITERATIVE PROCESS CAN GO ON TILL THE TWO VALUES ( IV AND THE VALUE USED TO DETERMINE THE WEIGHT) CONVERGE. FOR EXAMPLE IF YOU START WITH A MV OF 92.70 AND ESTIMATE THE IV AT 63.66 AND THEN USING ITERATIVE PROCESS, WE WILL ESTIMATE A VALUE OF 70.66 PER SHARE.
TWO –STAGE AND THREE- STAGE GROWTH MODEL:
SAME ASSUMPTIONS AND MODEL AS THAT FOR FCFE
PROF. NAVEEN BHATIA
4
FREE CASH FLOW TO A FIRM
FCFE VS FCFF:
THE VALUE FOR THE EQUITY OBTAINED FROM THE FIRM VALUATION EQUITY VALUATION WILL BE SAME IF ONE MAKES CONSISTEMNT ASSUMPTION ABOUT FINANCIAL LEVERAGES. A COST OF CAPITAL BASED ON MARKET VALUE WTS WILL NOT YIELD THE SAME VALUE FOR EQUITY AS AN EQUITY VALUATION MODEL IF THE FIRM IS NOT FAIRLY PRICED. THE INTEREST EXPENSES ARE EQUAL TO THE PRETAX COST OF DEBT MULTIPLIED BY MV OF DEBT. OF A FIRM HAS OLD DEBT ON ITS BOOKS, WITH INTEREST EXPENSES THAT ARE DIFFERENT FROM THIS VALUE, THE FCFE & FCFF APPROACH WILL DIVERGE.
PROF. NAVEEN BHATIA
5
FREE CASH FLOW TO A FIRM
EFFECT OF LEVERAGE ON A FIRMS VALUATION:
VALUE OF FIRM= SUM OF FCFF/ ( 1+WACC) IF WE ASSUME THAT FCFF ARE NOT AFFECTED BY THE CHOICE OF THE FINANCING MIX ( REMEMBER THEY ARE CASH FLOWS BEFORE INT ) AND THE COC REDUCES WITH THE INCREASING LEVERAGE THEN THE VALUE OF FIRM WILL INCREASE. THUS IF FCFF ARE UNAFFCTED BY LEVERAGE THE VALUE OF THE FIRM IS MAXIMISED BY MINIMISING THE COC. RECALL THAT BETA ( LEVERED) = B(UL) (1+(1-T)X D/E) THUS IF WE CAN ESTIMATE THE UNLEVERED BETA FOR A FIRM, WE CAN USE IT TO ESTIMATE THE LEVERED BETA OF A FIRM FOR EVERY DEBT RATIO. COST OF EQUITY= RFR + BETA ( LEVERED) ( RISK PREMIUM) THE COST OF DEBT FOR A FIRM IS A FUNCTION OF THE FIRM’S DEFAULT RISK. WE CAN NOW MEASURE THE FIRM’S WACC.
PROF. NAVEEN BHATIA
6
FREE CASH FLOW TO A FIRM
DEFAULT RISK, OPERATING INCOME & OPTIMAL LEVERAGE
THE OPERATING INCOME FOR MANY FIRMS WILL DROP AS THE DEFAULT RISK INCREASES. THE DROP IS LIKELY TO BE MORE PRONOUNCED AS THE DEFAULT RISK FALLS BELOW AN ACCEPTABLE LEVEL. FOR EXAMPLE , A BOND RATING BELOW INVESTMENT GRADE MAY TRIGER SIGNIFICANT LOSSES IN REVENUES AND INCREASE IN EXPENSES. IN SUCH A SCENARIO MAXIMISING A FIRMS VALUE REQUIRES LOOKING AT BOTH THE FIRMS CASH FLOWS AND THE WACC.
PROF. NAVEEN BHATIA
7
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