Present Value of Free Cash FlowThe two distinct approaches to using free cash flow for valuation are the FCFF valuationapproach and the FCFE valuation approach. The general expressions for these valuationmodels are similar to the expression for the general dividend discount model. In theDDM, the value of a share of stock equals the present value of forecasted dividendsfrom Time 1 through infinity discounted at the required rate of return for equity.

2.2.1 Present Value of FCFFThe FCFF valuation approach estimates the value of the firm as the present value offuture FCFF discounted at the weighted average cost of capital:

Because FCFF is the cash flow available to all suppliers of capital, using WACCto discount FCFF gives the total value of all of the firm’s capital. The value of equityis the value of the firm minus the market value of its debt:Equity value = Firm value – Market value of debtDividing the total value of equity by the number of outstanding shares gives the valueper share.

WACC = MV (Debt )

MV ( Debt )+MV (Equity)rd (1- Tax Rate) +

MV (Equity)MV ( Debt )+MV (Equity)

r

2.2.2 Present Value of FCFEThe value of equity can also be found by discounting FCFE at the required rate ofreturn on equity, r:

2.3 Single-Stage (Constant-Growth)FCFF and FCFE ModelsIn the DDM approach, the Gordon (constant- or stable-growth)model makes theassumption that dividends grow at a constant rate. The assumption that free cash flowsgrow at a constant rate leads to a single-stage(stable-growth)FCFF or FCFE model.32.3.1 Constant-Growth

FCFF Valuation ModelAssume that FCFF grows at a constant rate, g, such that FCFF in any period is equalto FCFF in the previous period multiplied by (1 + g):

Subtracting the market value of debt from the firm value gives the value of equity.

Using the Constant-GrowthFCFF Valuation ModelCipla Limited FCFF of Rs. 700 and FCFE of Rs. 620. Cipla’s before-tax cost of debt is 5.7 %, and its required rate of return for equity is 11.8 %. The company expects a target capital structure consisting of 20 % debt financing and 80 % equity financing.

The tax rate is 33.33 %, and FCFF is expected to grow forever at 5.%. Cipla Limited has debt outstanding with a market value of Rs.220 and has 200 outstanding common shares.1 What is Cipla Limited’s weighted average cost of capital?2 What is the value of Cipla Limited’s equity using the FCFF valuation approach?3 What is the value per share using this FCFF approach?

From Equation 3, WACC isWACC = 0.20(5.7%)(1 – 0.3333) + 0.80(11.8%) = 10.2%Solution to 2:The firm value of Cagiati Enterprises is the present value of FCFF discountedby using WACC. For FCFF growing at a constant 5 percent rate, the result is

Firm Value = FCFFo (1+g)

WACC−g =

700(1.05)0.102−0.05

= 735

0.05 2 = Rs.14,134.6

The value of equity is the value of the firm minus the value of debt:Equity value = 14,134.6 – 2,200 = CHF11,934.6 million

Solution to 3:Dividing CH11,934.6 million by the number of outstanding shares gives theestimated value per share, V0:V0 = CHF11,934.6 million/200 million shares= CHF59.67 per share

Constant-GrowthFCFE Valuation Model

The constant-growthFCFE valuation model assumes that FCFE grows at constant rateg. FCFE in any period is equal to FCFE in the preceding period multiplied by (1 + g):FCFEt = FCFEt–1(1 + g)The value of equity if FCFE is growing at a constant rate is

The discount rate is r, the required rate of return on equity. Note that the growth rateof FCFF and the growth rate of FCFE need not be and frequently are not the same.In this section, we presented the basic ideas underlying free cash flow valuationand the simplest implementation, single-stagefree cash flow models. The next sectionexamines the precise definition of free cash flow and introduces the issues involvedin forecasting free cash flow.

FORECASTING FREE CASH FLOWEstimating FCFF or FCFE requires a complete understanding of the company and itsfinancial statements. To provide a context for the estimation of FCFF and FCFE, wefirst use an extensive example to show the relationship between free cash flow andaccounting measures of income.For most of this section, we assume that the company has two sources of capital,debt and common stock. Once the concepts of FCFF and FCFE are understood fora company financed by using only debt and common stock, it is easy to incorporatepreferred stock for the relatively small number of companies that actually use it (inSection 3.8 we incorporate preferred stock as a third source of capital).

3.1 Computing FCFF from Net Income

3.2 Computing FCFF from the Statement of Cash Flows

3.3 Noncash ChargesFCFF = NI + NCC+ Int(1 − Tax rate) − FCInv − WCInv,

3.4 Computing FCFE from FCFF

3.5 Finding FCFF and FCFE from EBIT or EBITDAFCFF = EBIT(1 – Tax rate) + Dep – FCInv – WCInv

The relationship between FCFF and EBITDA can also be easily shown. Net incomecan be expressed asFCFF = EBITDA(1 – Tax rate) + Dep(Tax rate) – FCInv – WCInvFCFE = FCFF – Int(1 – Tax rate) + Net borrowing

The Pitts Corporation (financial statements provided in Example 6) had EBIT of$500 million and EBITDA of $800 million in 2012. Show the adjustments thatwould be required to find FCFF and FCFE:1 Starting from EBIT.2 Starting from EBITDA.

3.7 Forecasting FCFF and FCFEWelch Corporation uses bond, preferred stock, and common stock financing. Themarket value of each of these sources of financing and the before-taxrequiredrates of return for each are given in Exhibit 13:

Other financial information (dollars in millions):■■ Net income available to common shareholders = $110.■■ Interest expenses = $32.■■ Preferred dividends = $8.■■ Depreciation = $40.■■ Investment in fixed capital = $70.■■ Investment in working capital = $20.■■ Net borrowing = $25.■■ Tax rate = 30 percent.■■ Stable growth rate of FCFF = 4.0 percent.■■ Stable growth rate of FCFE = 5.4 percent.1 Calculate Welch Corporation’s WACC.2 Calculate the current value of FCFF.3 Based on forecasted Year 1 FCFF, what is the total value of WelchCorporation and the value of its equity?4 Calculate the current value of FCFE.5 Based on forecasted Year 1 FCFE, what is the value of equity?

John Jones, CFA, is head of the research department of Peninsular Research.One of the companies he is researching, Mackinac Inc., is a US-basedmanufacturingcompany. Mackinac has released the June 2007 financial statementsshown in Exhibits 1, 2, and 3.