Free Cash Flow and Other Valuation Models, LOS 31-34 Questions and Answers

Free Cash Flow and Other Valuation Models, LOS 31-34 Questions and Answers When to use FCFF instead of Div Discount Method appropriate models to use when (1) the firm doesn't pay dividends at all or pays out fewer dividends than dictated by its cash flow, (2) free cash flow tracks profitability, or (3) the analyst takes a corporate control perspective Warm-Up: Free Cash Flow Forget about all the complicated financial statement relationships for a minute and simply picture the firm as a cash processor. Cash flows into the firm in the form of revenue as it sells its product, and cash flows out as it pays its cash operating expenses (e.g., salaries and taxes, but not interest expense, which is a financing and not an operating expense). The firm takes the cash that's left over and makes short-term net investments in working capital (e.g., inventory and receivables) and long-term investments in property, plant, and equipment (PP&E). The cash that remains is available to pay out to the firm's investors: bondholders and common shareholders (let's assume for the moment that the firm has not issued preferred stock). That pile of remaining cash is called free cash flow to the firm (FCFF) because it's free to pay out to the firm's investors (see Figure 1). Free Cash Flow to the Firm The formal definition of FCFF is the cash available to all of the firm's investors, including stockholders and bondholders, after the firm buys and sells products, provides services, pays its cash operating expenses, and makes short- and long-term investments. Professors Note on FCFF Professor's Note: Taxes paid are included in the definition of cash operating expenses for purposes of defining free cash flow, even though taxes aren't generally considered a part of operating income. What does the firm do with its FCFF? First, it takes care of its bondholders because common shareholders are paid after all creditors. So it makes interest payments to bondholders and borrows more money from them or pays some of it back. However, making interest payments to bondholders has one advantage for common shareholders: it reduces the tax bill. LOS 31.a: Compare the free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) approaches to valuation. What makes this complicated is that we'll end up with two values we want to estimate (firm value and equity value), two cash flow definitions (FCFF and FCFE), and two required returns [weighted average cost of capital (WACC) and required return on equity]. The key to this question on the exam is knowing which cash flows to discount at which rate to estimate which value. Firm Value = firm value = FCFF discounted at the WACC Equity Value = equity value = firm value - market value of debt When doing Discounting using FCF always discount FCFF at the WACC to find firm value and FCFE at the required return on equity to estimate equity value. LOS 31.b: Explain the ownership perspective implicit in the FCFE approach The ownership perspective in the free cash flow approach is that of an acquirer who can change the firm's dividend policy, which is a control perspective, or for minority shareholders of a company that is in-play (i.e., it is a takeover target with potential bidders). The ownership perspective implicit in the dividend discount approach is that of a minority owner who has no direct control over the firm's dividend policy. If investors are willing to pay a premium for control of the firm, there may be a difference between the values of the same firm derived using the two models. Analysts often prefer to use FCF rather than Div based valuation for the following reasons Many firms pay no, or low, cash dividends. Dividends are paid at the discretion of the board of directors. It may, consequently, be poorly aligned with the firm's long-run profitability. If a company is viewed as an acquisition target, free cash flow is a more appropriate measure because the new owners will have discretion over its distribution (control perspective). Free cash flows may be more related to long-run profitability of the firm as compared to dividends. LOS 31.c: Explain the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE. The basic idea is that we can arrive at FCFF by starting with one of four different financial statement items (net income, EBIT, EBITDA, or cash flow from operations [CFO]) and then making the appropriate adjustments. Then we can calculate FCFE from FCFF or by starting with net income or CFO Important adjustments to NI Notice that net income does not represent free cash flows defined as FCFF, so we have to make four important adjustments to net income to get to FCFF: noncash charges, fixed capital investment, working capital investment, and interest expense. Noncash charges Noncash charges are added back to net income to arrive at FCFF because they represent expenses that reduced reported net income but didn't actually result in an outflow of cash. The most significant noncash charge is usually depreciation. Other Non-cash charges Amortization of intangibles should be added back to net income, much like depreciation. Provisions for restructuring charges and other noncash losses should be added back to net income. However, if the firm is accruing these costs to cover future cash outflows, then the forecast of future free cash flow should be reduced accordingly. Gains or losses on sale of long-term assets are also removed (they would be accounted for under fixed capital investment). Income from restructuring charge reversals and other noncash gains should be subtracted from net income. For a bond issuer, the amortization of a bond discount should be added back to net income, and the accretion of the bond premium should be subtracted from net income to calculate FCFF. Deferred taxes, which result from differences in the timing of reporting income and expenses for accounting versus tax purposes, must be carefully analyzed. Over time, differences between book and taxable income should offset each other and have no significant effect on overall cash flows. If, however, the analyst expects deferred tax liabilities to continue to increase (i.e., not reverse), increases in deferred tax liabilities should be added back to net income. Increases in deferred tax assets that are not expected to reverse should be subtracted from net income. Fixed capital investment Investments in fixed capital do not appear on the income statement, but they do represent cash leaving the firm. That means we have to subtract them from net income to estimate FCFF. Fixed capital investment is a net amount: it is equal to the difference between capital expenditures (investments in long-term fixed assets) and the proceeds from the sale of long-term assets: FCInv = capital expenditures - proceeds from sales of long-term assets If no long-term assets were sold during the year, then capital expenditures will also equal the change in the gross PP&E account from the balance sheet If no long-term assets were sold during the year: FCInv = ending net PP&E - beginning net PP&E + depreciation If long-term assets were sold during the year, then: Determine capital expenditures from either (1) an item in the statement of cash flows called something like "purchase of fixed assets" or "purchases of PP&E" under cash flow from investing activities, or (2) data provided in the vignette. Determine proceeds from sales of fixed assets from either (1) an item in the statement of cash flows called something like "proceeds from disposal of fixed assets," or (2) data provided in the vignette. Calculate FCInv = capital expenditures - proceeds from sale of long-term assets. If capital expenditures or sales proceeds are not given directly, find gain (loss) on asset sales from the income statement and PP&E figures from balance sheet. Calculate FCInv = ending net PP&E - beginning net PP&E + depreciation - gain on sale. If there is a loss on sale of assets, add that instead of deducting it. Calculating FCInv with no long-term asset sales Calculating FCInv with no long-term asset sales Answer Example: Calculating FCInv with long-term asset sales Suppose that Air Brush reports capital expenditures of $1,400, long-term asset sales of $600, and depreciation expense of $850. The long-term assets sold were fully depreciated. Calculate Airbrush's revised FCInv for 2017. Answer: revised FCInv = capital expenditures - proceeds from sales of long-term assets = $1,400 - $600 = $800 Working capital investment The investment in net working capital is equal to the change in working capital, excluding cash, cash equivalents, notes payable, and the current portion of long-term debt. Note that there would be a + sign in front of a reduction in working capital; we would add it back because it represents a cash inflow. Interest Expense Interest was expensed on the income statement, but it represents a financing cash flow to bondholders that is available to the firm before it makes any payments to its capital suppliers. Therefore, we have to add it back. However, we don't add back the entire interest expense, only the after-tax interest cost because paying interest reduces our tax bill. For example, if the marginal tax rate is 30%, every dollar of interest paid reduces the tax bill by 30 cents. The net effect on free cash flow is an increase in the after-tax interest cost of 70 cents. Free cash flow to the firm is the operating cash flow left after the firm makes working capital and fixed capital investment. Therefore, we can get close to the actual calculation by using the first column in Figure 2: (Almost) FCFF= (NI + NCC - WCInv) - FCInv= CFO - FCInv But we are not quite there: because of one unique feature of the statement of cash flows: interest expense is considered an operating cash flow, whereas we'd like to call it a financing cash flow. Because interest is tax deductible, the after-tax interest expense [interest × (1 - tax rate)] reduces net income; but, we want to add it back to net income and then subtract it out as a financing cash outflow. By doing that, we go from our (almost) definition to the actual formula for FCFF (as shown in the second column in Figure 2): (Actual) FCFF= (NI + NCC - WCInv) + Int(1 - tax rate) - FCInv= CFO + Int(1 - tax rate) - FCInv We can also use the second column format to calculate FCFE directly from FCFF: FCFE = FCFF - Int(1 - tax rate) + net borrowing Notice that any financial decisions that affect cash flows below FCFE (e.g., dividends, share repurchases, and share issues) do not affect FCFF or FCFE. Calculating FCFF from EBIT. FCFF can also be calculated from earnings before interest and taxes (EBIT): FCFF = [EBIT × (1 - tax rate)] + Dep - FCInv - WCInv where: EBIT = earnings before interest and taxes Dep = depreciation If we start with earnings before interest and taxes (EBIT), we have to If we start with earnings before interest and taxes (EBIT), we have to add back depreciation because it was subtracted out to get to EBIT. However, because EBIT is before interest and taxes, we don't have to take out interest (remember that it's a financing cash flow). We do have to adjust for taxes, though, by computing after-tax EBIT, which is EBIT multiplied by one minus the tax rate. We also make the same adjustments as we did before by subtracting out fixed capital and working capital investment. Professor's Note: Because many noncash adjustments occur on the income statement below EBIT, we don't need to adjust for them when calculating free cash flow if we start with EBIT. We assume that the only noncash charge that appears above EBIT is depreciation in the equation "FCFF from EBIT." In general, however, the rule is to adjust for any noncash charge that appears on the income statement abo ve the income statement item you're starting with. Calculating FCFF from EBITDA. We can also start with earnings before interest, taxes, depreciation, and amortization (EBITDA) to arrive at FCFF: FCFF = [EBITDA × (1 - tax rate)] + (Dep × tax rate) - FCInv - WCInv where: EBITDA = earnings before interest,taxes, depreciation, and amortization Remember that EBITDA is before depreciation, so we only have to add back the depreciation tax shield, which is depreciation multiplied by the tax rate. Even though depreciation is a noncash expense, the firm reduces its tax bill by expensing it, so the free cash flow available is increased by the taxes saved. Calculating FCFF from CFO. Finally, FCFF can also be estimated by starting with cash flow from operations (CFO) from the statement of cash flows: FCFF = CFO + [Int × (1 - tax rate)] - FCInv where: CFO = cash flow from operations Cash flow from operations is equal to net income plus noncash charges less working capital investment. We have to add back to CFO the after-tax interest expense to get to FCFF because interest expense (and the resulting tax shield) was reflected on the income statement to arrive at net income. We also have to subtract out fixed capital investment since CFO only includes changes in working capital investment. Calculating FCFE from FCFF. Calculating FCFE is easy once we have FCFF: FCFE = FCFF - [Int × (1 - tax rate)] + net borrowing where: net borrowing = long- and short-term new debt issues - long- and short-term debt repayments Calculating FCFE from net income. We can also calculate FCFE from net income by making some of the usual adjustments. FCFE = NI + NCC - FCInv - WCInv + net borrowing The two differences between this "FCFE from net income" formula and the "FCFF from net income formula" are (1) after-tax interest expense is not added back and (2) net borrowing is added back. Calculating FCFE from CFO. FCFE = CFO - FCInv + net borrowing Finally, we can calculate FCFE from CFO by subtracting out fixed capital investment (which reduces cash available to shareholders) and adding back net borrowing (which increases the cash available to shareholders). Free Cash Flow With Preferred Stock The FCFF and FCFE formulas assume that the company uses only debt and common equity to raise funds. The use of preferred stock requires the analyst to revise the FCFF and FCFE formulas to reflect the payment of preferred dividends and any issuance or repurchase of such shares. Remember to treat preferred stock just like debt, except preferred dividends are not tax deductible. Specifically, any preferred dividends should be added back to the FCFF, just as after-tax interest charges are in the net income approach to generating FCFF. This approach assumes that net income is net income to common shareholders after preferred dividends have been subtracted out. The WACC should also be revised to reflect the percent of total capital raised by preferred stock and the cost of that capital source. The only adjustment to FCFE would be to modify net borrowing to reflect new debt borrowing and net issuances by the amount of the preferred stock. Keep in mind that relatively few firms issue preferred stock. Example: Calculating FCFF and FCFE Anson Ford, CFA, is analyzing the financial statements of Sting's Delicatessen. He has a 2009 income statement and balance sheet, as well as 2010 income statement, balance sheet, and cash flow from operations forecasts (as shown in the tables below). Assume there will be no sales of long-term assets in 2010. Calculate forecasted free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) for 2010. Stings IS Stings BS Sting Operating Projections Sting Answer Answer: Fixed capital investment is equal to capital expenditures (because there are no asset sales), which is equal to the change in net PP&E plus depreciation: FCInv = (210 - 160) + 50= 100 Working capital investment is the change in the working capital accounts, excluding cash and short-term borrowings: WCInv = (AcctsRec2010 + Inv2010 - AcctsPay2010) -(AcctsRec2009 + Inv2009 - AcctsPay2009) WCInv = (30 + 40 - 20) - (15 + 30 - 20) = 50 - 25 = 25 Given that depreciation is the only noncash charge, we can calculate FCFF from net income: FCFF= NI + NCC + [Int × (1 - tax rate)] - FCInv - WCInv= 56 + 50 + [15 × (1 - 0.3)] - 100 - 25 = -8.5= 56 + 50 + 10.5 - 100 - 25 = -8.5 It's entirely possible that FCFF can be negative in the short term. We'll talk more later about how to value firms with negative FCFF. Net borrowing is the difference between the long-term and short-term debt accounts: net borrowing = (114 + 20) - (100 + 10) = 24 FCFE= FCFF - [Int(1 - tax rate)] + net borrowing= -8.5 - 10.5 + 24 = 5 Example: Calculating FCFF and FCFE with the other formulas Calculate FCFF starting with EBIT, EBITDA, and CFO, and calculate FCFE starting with NI and CFO. Answer: FCFF= [EBIT × (1 - tax rate)] + Dep - FCInv - WCInv= [95 × (1 - 0.3)] + 50 - 100 - 25 = -8.5 FCFF= [EBITDA × (1 - tax rate)] + (Dep × tax rate) - FCInv - WCInv= [145 × (1 - 0.3)] + (50 × 0.3) - 100 - 25 = -8.5 FCFF= CFO + [Int × (1 - tax rate)] - FCInv= 81 + [15 × (1 - 0.3)] - 100 = -8.5 FCFE= NI + Dep - FCInv - WCInv + net borrowing= 56 + 50 - 100 - 25 + 24 = 5 FCFE= CFO - FCInv + net borrowing= 81 - 100 + 24 = 5 LOS 31.e: Describe approaches for forecasting FCFF and FCFE. Two approaches are commonly used to forecast future FCFF and FCFE. 1st common approach to forecast future FCFF and FCFE The first method is to calculate historical free cash flow and apply a growth rate under the assumptions that growth will be constant and fundamental factors will be maintained Ex:For example, we could calculate free cash flow in the most recent year and then forecast it to grow at 8% for four years and 4% forever after that. This is the same method we used for dividend discount models. Note that the growth rate for FCFF is usually different than the growth rate for FCFE.