1 (of 22) FIN 468: Intermediate Corporate Finance Topic 5–Free Cash Flow Larry Schrenk, Instructor

Exam 1 Structure Length1 hour Format100 Points  Short Answer50 Points(10 Questions)  Calculations50 Points(5-8 Questions) MaterialsFinancial Calculator  No Crib Sheets, Formulae Sheets, etc.  You only need to know the formulae for ratios mentioned on slides or discussed in class. 2 (of 70)

Exam Short Answer Preparation Slides and Notes  Main Ideas Textbook  Main Ideas  Learning Outcomes  Bold Terms  Chapter Summaries  EoC Problems: Conceptual Issues 3 (of 70)

Exam Calculation Preparation Slides and Notes  Main Calculations Textbook  Calculations in Text  EoC Problems: Calculations 4 (of 70)

Topics Why Free Cash Flow (FCF)? The Free Cash Flow Method Problems with Free Cash Flow Free Cash Flow Example

Why Free Cash Flow?

Dividends versus FCF Dividends  Cash Flows Actually Paid to Stockholders Free Cash Flows  Cash Flows Available for Distribution 7 (of 70)

Problems with DDM Distribution, not Creation, of Value Arbitrary and Hard to Predict Retained Earnings Problem Much Value Far in the Future Cannot use to Value Firm Agency Issues Cash flows should reflect ability to pay dividends, not what was actually paid

FCF Situations No Dividends Dividend Differ from Capacity to Pay Free Cash Flows Align with Profitability Control Perspective 9 (of 70)

The Free Cash Flow Method 10 (of 70)

Free Cash Flow Free Cash Flow = Cash Flow Available  Available??? No Definition  Like Ratios Theoretical, not Observable, Value 11 (of 70)

FCFF versus FCFE Free Cash Flow–Firm (FCFF)  Enterprise Cash Flow  Value the Entire Firm Free Cash Flow–Equity (FCFE)  Value Equity  Issue: Preferred Shares 12 (of 70)

Free Cash Flow–Firm (FCFF) Cash Flow Available to…  Repay Lenders  Pay Common and Preferred Dividends  Repurchase Equity  Call Debt Adjustments to Net Income  Interest and Principal Payments  Non-Cash Items  Δ Working Capital  Δ Capital Expenditures 13 (of 70)

Free Cash Flow–Firm (FCFF) Net Income +Interest and Principal Payments +Non-Cash Items (e.g., Depreciation) – ΔNet Working Capital – Δ Capital Expenditures FCFF 14 (of 70)

Free Cash Flow–Equity (FCFE) Cash Flow Available to…  Repay Lenders  Pay Common and Preferred Dividends  Repurchase Equity Adjustments to Net Income  Interest and Principal Payments  Non-Cash Items  Δ Working Capital  Δ Capital Expenditures 15 (of 70)

Free Cash Flow–Equity (FCFE) Net Income +Non-Cash Items (e.g., Depreciation) – ΔNet Working Capital – Δ Capital Expenditures FCFE 16 (of 70)

Alternate FCFE Method Derive Value form FCFF FCFF – Value of Debt FCFE 17 (of 70)

18 Possible CF Growth Patterns FCF Constant  No-Growth Assumption FCF Changing at Constant Rate  Constant Growth Assumption Neither  Variable Growth Assumption

The Cash Flows The Income Statement  Net Income  Use This Method The Statement of Cash Flows  Cash Flow from Operations 19 (of 70)

Interest and Principal Payments After Tax Interest Payment  Interest x (1 –  c ) Principal Repayment?  Target Capital Structure 20 (of 70)

Non-Cash Adjustments Non-Cash ItemAdjustment to Net Income DepreciationAdded Back Amortization of intangiblesAdded Back Restructuring Charges (expense)Added Back LossesAdded Back GainsSubtracted Amortization of long-term bond discountsAdded Back Amortization of long-term bond premiumSubtracted Deferred Taxes None 21 (of 70)

Forecasting Cash Flows Historical Data  Historical Growth Rate  Best for Constant Growth  Past Predictive of Future New Information 22 (of 70)

Forecasting Capital Expenditures Two Components  Net Expenditures to Maintain Assets-in-Place  New Expenditures to Support Growth Opportunities 23 (of 70)

Terminal value Firms are Infinite Perpetuity or Growing Perpetuity WARNING: Delayed Perpetuity 24 (of 70)

Discount Rate FCFF  WACC FCFE  Required Return on Equity More in Cost of Capital 25 (of 70)

Problems with Free Cash Flow 26 (of 70)

Technical Problems Free cash flow forecasts are generally not available Generally must compute statement of cash flows from:  earnings forecasts  balance sheet assumptions Much of value comes far in the future

Capital Expenditures “Cash flow available to the firm’s suppliers of capital after all operating expenses have been paid and necessary investments in working capital and fixed capital have been made.” What is ‘necessary’?” 28 (of 70)

Growth Estimation Past versus Future Sensitivity 29 (of 70)

Free Cash Flow Example 30 (of 70)

Income Statement 31 (of 70)

Parameters Rates  WACC 12%  Return on Equity 17% Adjustments  ΔNet Working Capital$5,000,000  ΔCapital Expenditures $35,000,000 Growth Rates  g1-4 20%  g5+ 2% 32 (of 70)

Initial FCFF 33 (of 70)

FCFF Valuation 34 (of 70)

Initial FCFE 35 (of 70)

FCFE Valuation 36 (of 70)