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Understanding Free Cash Flows: Valuation of Firms and Equity Holders

This guide explores Free Cash Flows (FCF) to the Firm (FCFF) and Equity Holders (FCFE), crucial for valuation. FCFF measures cash available to debtholders and equity holders, derived from Net Income, Capital Expenditures, and changes in working capital. Valuation involves forecasting FCFF, obtaining the weighted average cost of capital (WACC), and constructing the firm’s value. FCFE focuses on what is available to equity holders, incorporating net income adjustments and debt changes. Learn the steps and models to effectively assess firm growth and equity value.

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Understanding Free Cash Flows: Valuation of Firms and Equity Holders

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  1. Class Business • Upcoming Case

  2. Free Cash Flows • Free Cash Flows to the Firm (FCFF) • Cash flows available to debtholders, equity holders (common and preferred) • Free Cash Flows to Equity Holders • Cash flows available to equity holders (common and preferred)

  3. Free Cash Flows to Firmand Valuation • Definition: FCFF = EBIT(1-tax rate) – (Capital Expenditures – Depreciation) – (Change in working capital) • Valuation Steps: • Construct forecasts of FCFF • Obtain discount rate for cash flows (WACC) • Construct Value of Firm • Subtract off Market value of Debt

  4. Free Cash Flows to Equity and Valuation • Definition: FCFE = Net income – (Capital Expenditures – Depreciation) – (Change in working capital) + (New Debt issued – Debt repayments) + (New Preferred Issues – Preferred Dividends) • Valuation Steps: • Construct forecasts of FCFE • Obtain discount rate for cash flows (k) - CAPM • Construct Equity Value of Firm

  5. Growth Rates • Dividend Model • g = ROE*b • FCFE Model • gFCFE = NROE*ERR • ERR = 1 – (Net Capital Expenditures + Change in Working Capital – Net Debt Issues)/Net Income • NROE = (Net Income – After-tax income from cash and marketable securities)/(Book value of equity – Cash and marketable securities)

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