Free Cash Flows FCFF & Fcfe
Free Cash Flows FCFF & Fcfe
Shareholder Value
Present value
of Free Cash
Flows
Shareholder value based on value drivers: links SHV to operating,
investment and financing decisions
Shareholder
Value
• FCFE = NI - Δ CSE
FCFF
Firm Valuation
If we assume that the net capital expenditures and working capital changes
are financed using a fixed mix of debt and equity. If d is the proportion
that is raised from debt financing,
•Non-cash ROE
(Net Income - After tax income from cash and marketable securities) / (Book
Value of Equity - Cash and Marketable Securities)
•better model to use for stable firms that pay out dividends that
are unsustainably high (because they exceed FCFE by a
significant amount) or are significantly lower than the FCFE
•if the firm is stable and pays outs its FCFE as dividend, the value
obtained from this model will be the same as the one obtained
from the Gordon growth model
Two – Stage FCFE Model
• Caveats
– the assumptions made to derive the free cashflow to
equity after the terminal year have to be consistent with
the assumption of stability. For instance, while capital
spending may be much greater than depreciation in the
initial high growth phase, the difference should narrow
as the firm enters its stable growth phase
– The beta and debt ratio may also need to be adjusted in
stable growth to reflect the fact that stable growth firms
tend to have average risk (betas closer to one)
Two – Stage FCFE Model
FCFE 3 Stage Model
• Caveats
– Since the model assumes that the growth rate goes
through three distinct phases -high growth, transitional
growth and stable growth - it is important that
assumptions about other variables are consistent with
these assumptions about growth
– As the growth characteristics of a firm change, so do its
risk characteristics. In the context of the CAPM, as the
growth rate declines, the beta of the firm can be
expected to change
Leverage, FCFE and Value
•In a discounted cash flow model, increasing the debt/equity ratio will
generally increase the expected free cash flows to equity investors
over future time periods and also the cost of equity applied in
discounting these cash flows.
•Which of the following statements relating leverage to value would
you subscribe to?
– Increasing leverage will increase value because the cash flow
effects will dominate the discount rate effects
– Increasing leverage will decrease value because the risk effect
will be greater than the cash flow effects
– Increasing leverage will not affect value because the risk effect
will exactly offset the cash flow effect
Leverage, FCFE and Value
– Any of the above, depending upon what company you are
looking at and where it is in terms of current leverage
Estimating Value
Assets
ROCE=Earning / CSE
= RNOA + (FLEV X SPREAD)
Interest expense and MI
Dell, Oracle,
Level 2 PM = OI / sales ATO = sales / NOA
HUL, GM,
MICROSOFT
• High margins and high turnovers : printing and publishing and chemicals
• Low turnovers and high margins : pipelines, shipping, utilities and communications
• High turnovers and low margins : food stores, apparels, retail stores
Key Drivers : Select Industries
Cellular phones Population covered and churn rates Sales and ATO
Commercial real estate Square footage and occupancy rates Sales and ATO
Retail Retail space and sales per square foot Sales and ATO