Forecasting and Valuation of Free Cash Flows Arzac, Chapter 2

Firm Valuation Forecast FCF Estimate Cost of Capital Estimate Continuation Value Overall 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 V N 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