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Forecasting and Valuation of Free Cash Flows

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## Forecasting and Valuation of Free Cash Flows

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**Forecasting and Valuation of Free Cash Flows**Arzac, Chapter 2**Firm Valuation**• historical financial statements • forecast period • opportunity costs of capital • market value weight • make assumptions for continuation value • use formula to get value • check different scenarios**Firm Valuation**• DCF valuation - incorporates estimates of FCF for set number of years with calculation of continuation value at end • multiples approach – comparable companies or comparable transactions**FCF Calculation**• start with NI • add net interest expense after tax to get unlevered NI • (1-T)(Int. Exp. – Int. Inc.) = Unlevered NI • add back changes in deferred taxes and depreciation • noncash • ↑ def taxes is source of cash • depreciation can include all noncash charges deducted from EBIT except for goodwill**FCF Valuation**• deferred taxes + unlevered NI = NOPAT • depreciation to NOPAT = Gross CF • total CF given off by firm • Gross CF – Gross Inv. = FCF (operations) • Gross Investment = • increase in WC • + capital expenditures • + investment in goodwill • + increase in net other assets**Financial Flows**• includes all interest-earning or interest-paying financial securities and equity • independent estimate from FCF • must be equal to FCF (good check!)**Estimating FCF**• forecast financial statements • consistency • compare with analysts ? • common forecasting error • “plugs” for building balance sheet • calculate FCF for set number of years • how long?**Estimating FCF**• Continuation Value • idea is that over time most firms regress to industry norm • estimate FCFs over period of “competitive advantage” relative to industry and then make growth assumptions with firm converging to industry norm – i.e., constant growth**Estimating FCF**• assumption that competition drives return on invested capital in LR to equal WACC • perpetuity model • growth rate in CF not relevant because no value creation • discount VN back to time 0 (discount using?)**Estimating FCF**• value driver model • dominant firm in industry – Microsoft, Coca-Cola • potential to earn high returns on invested capital for very long time • discount to get value at T=0