CHAPTER

4
FREE CASH FLOW
VALUATION

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following :

• Define and interpret free cash flow to the firm (FCFF) and free cash flow to equity
(FCFE).
• Describe, compare, and contrast the FCFF and FCFE approaches to valuation.
• Contrast the ownership perspective implicit in the FCFE approach to the ownership per-
spective implicit in the dividend discount approach.
• Discuss the appropriate adjustments to net income, earnings before interest and taxes
(EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and
cash flow from operations (CFO) to calculate FCFF and FCFE.
• Calculate FCFF and FCFE when given a company’s financial statements prepared accord-
ing to International Financial Reporting Standards (IFRS) or U.S. generally accepted
accounting principles (GAAP).
• Discuss approaches for forecasting FCFF and FCFE.
• Contrast the recognition of value in the FCFE model to the recognition of value in divi-
dend discount models.
• Explain how dividends, share repurchases, share issues, and changes in leverage may affect
FCFF and FCFE.
• Critique the use of net income and EBITDA as proxies for cash flow in valuation.
• Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE mod-
els (including assumptions) and explain the company characteristics that would justify the
use of each model.
• Calculate the value of a company by using the stable-growth, two-stage, and three-stage
FCFF and FCFE models.
• Explain how sensitivity analysis can be used in FCFF and FCFE valuations.
• Discuss approaches for calculating the terminal value in a multistage valuation model.
• Describe the characteristics of companies for which the FCFF model is preferred to the
FCFE model.

145

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 146 Equity Asset Valuation

1. INTRODUCTION TO FREE CASH FLOWS

Discounted cash flow (DCF) valuation views the intrinsic value of a security as the present value
of its expected future cash flows. When applied to dividends, the DCF model is the discounted
dividend approach or dividend discount model (DDM). This chapter extends DCF analysis to
value a company and its equity securities by valuing free cash flow to the firm (FCFF) and free
cash flow to equity (FCFE). Whereas dividends are the cash flows actually paid to stockholders,
free cash flows are the cash flows available for distribution to shareholders.
Unlike dividends, FCFF and FCFE are not readily available data. Analysts need to com-
pute these quantities from available financial information, which requires a clear understand-
ing of free cash flows and the ability to interpret and use the information correctly. Forecasting
future free cash flows is also a rich and demanding exercise. The analyst’s understanding of a
company’s financial statements, its operations, its financing, and its industry can pay real “divi-
dends” as he addresses that task. Many analysts consider free cash flow models to be more use-
ful than DDMs in practice. Free cash flows provide an economically sound basis for valuation.
Analysts like to use free cash flow as the return (either FCFF or FCFE) whenever one or
more of the following conditions is present:

• The company does not pay dividends.

• The company pays dividends but the dividends paid differ significantly from the company’s
capacity to pay dividends.
• Free cash flows align with profitability within a reasonable forecast period with which the
analyst is comfortable.
• The investor takes a control perspective. With control comes discretion over the uses of
free cash flow. If an investor can take control of the company (or expects another investor
to do so), dividends may be changed substantially; for example, they may be set at a level
approximating the company’s capacity to pay dividends. Such an investor can also apply
free cash flows to uses such as servicing the debt incurred in an acquisition.

Common equity can be valued directly by using FCFE or indirectly by first using
an FCFF model to estimate the value of the firm and then subtracting the value of non-
common-stock capital (usually debt) from FCFF to arrive at an estimate of the value of
equity. The purpose of this chapter is to develop the background required to use the FCFF or
FCFE approaches to value a company’s equity.
Section 2 defines the concepts of free cash flow to the firm and free cash flow to equity and
then presents the two valuation models based on discounting of FCFF and FCFE. We also explore
the constant-growth models for valuing FCFF and FCFE, which are special cases of the gen-
eral models, in this section. After reviewing the FCFF and FCFE valuation process in Section 2,
we turn in Section 3 to the vital task of calculating and forecasting FCFF and FCFE. Section 4
explains multistage free cash flow valuation models and presents some of the issues associated with
their application. Analysts usually value operating assets and nonoperating assets separately and
then combine them to find the total value of the firm, an approach described in Section 5.

2. FCFF AND FCFE VALUATION APPROACHES

The purpose of this section is to provide a conceptual understanding of free cash flows
and the valuation models based on them. A detailed accounting treatment of free cash flows and
more complicated valuation models follow in subsequent sections.

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 Chapter 4 Free Cash Flow Valuation 147

2.1. Defining Free Cash Flow

Free cash flow to the firm is the cash flow available to the company’s suppliers of capital
after all operating expenses (including taxes) have been paid and necessary investments in
working capital (e.g., inventory) and fixed capital (e.g., equipment) have been made. FCFF
is the cash flow from operations minus capital expenditures. A company’s suppliers of capi-
tal include common stockholders, bondholders, and sometimes, preferred stockholders. The
equations analysts use to calculate FCFF depend on the accounting information available.
Free cash flow to equity is the cash flow available to the company’s holders of common
equity after all operating expenses, interest, and principal payments have been paid and neces-
sary investments in working and fixed capital have been made. FCFE is the cash flow from
operations minus capital expenditures minus payments to (and plus receipts from) debt holders.
The way in which free cash flow is related to a company’s net income, cash flow from
operations, and measures such as EBITDA (earnings before interest, taxes, depreciation, and
amortization) is important: The analyst must understand the relationship between a com-
pany’s reported accounting data and free cash flow in order to forecast free cash flow and
its expected growth. Although a company reports cash flow from operations (CFO) on the
statement of cash flows, CFO is not free cash flow. Net income and CFO data can be used,
however, in determining a company’s free cash flow.
The advantage of FCFF and FCFE over other cash flow concepts is that they can be
used directly in a DCF framework to value the firm or to value equity. Other cash flow– or
earnings-related measures, such as CFO, net income, EBIT, and EBITDA, do not have this
property because they either double-count or omit cash flows in some way. For example,
EBIT and EBITDA are before-tax measures, and the cash flows available to investors (in
the firm or in the equity of the firm) must be after tax. From the stockholders’ perspective,
EBITDA and similar measures do not account for differing capital structures (the after-tax
interest expenses or preferred dividends) or for the funds that bondholders supply to finance
investments in operating assets. Moreover, these measures do not account for the reinvest-
ment of cash flows that the company makes in capital assets and working capital to maintain
or maximize the long-run value of the firm.
Using free cash flow in valuation is more challenging than using dividends because
in forecasting free cash flow, the analyst must integrate the cash flows from the company’s
operations with those from its investing and financing activities. Because FCFF is the after-
tax cash flow going to all suppliers of capital to the firm, the value of the firm is estimated
by discounting FCFF at the weighted average cost of capital (WACC). An estimate of the
value of equity is then found by subtracting the value of debt from the estimated value of
the firm. The value of equity can also be estimated directly by discounting FCFE at the
required rate of return for equity (because FCFE is the cash flow going to common stock-
holders, the required rate of return on equity is the appropriate risk-adjusted rate for dis-
counting FCFE).
The two free cash flow approaches, indirect and direct, for valuing equity should theo-
retically yield the same estimates if all inputs reflect identical assumptions. An analyst may
prefer to use one approach rather than the other, however, because of the characteristics of
the company being valued. For example, if the company’s capital structure is relatively stable,
using FCFE to value equity is more direct and simpler than using FCFF. The FCFF model is
often chosen, however, in two other cases:

1. A levered company with negative FCFE. In this case, working with FCFF to value the
compan.y’s equity might be easiest. The analyst would discount FCFF to find the present

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 148 Equity Asset Valuation

value of operating assets (adding the value of excess cash and marketable securities and of
any other significant nonoperating assets1 to get total firm value) and then subtract the
market value of debt to obtain an estimate of the intrinsic value of equity.
2. A levered company with a changing capital structure. First, if historical data are used to fore-
cast free cash flow growth rates, FCFF growth might reflect fundamentals more clearly
than does FCFE growth, which reflects fluctuating amounts of net borrowing. Second, in
a forward-looking context, the required return on equity might be expected to be more
sensitive to changes in financial leverage than changes in the WACC, making the use of a
constant discount rate difficult to justify.

Specialized DCF approaches are also available to facilitate the equity valuation when the
capital structure is expected to change.2
In the following, we present the general form of the FCFF valuation model and the
FCFE valuation model.

2.2. Present Value of Free Cash Flow

The two distinct approaches to using free cash flow for valuation are the FCFF valuation
approach and the FCFE valuation approach. The general expressions for these valuation
models are similar to the expression for the general dividend discount model. In the DDM,
the value of a share of stock equals the present value of forecasted dividends from time 1
through infinity discounted at the required rate of return for equity.

2.2.1. Present Value of FCFF

The FCFF valuation approach estimates the value of the firm as the present value of future
FCFF discounted at the weighted average cost of capital:
∞
FCFFt
Firm value  ∑ (4-1)
t 1 (1 WACC )t
Because FCFF is the cash flow available to all suppliers of capital, using WACC to dis-
count FCFF gives the total value of all of the firm’s capital. The value of equity is the value of
the firm minus the market value of its debt:
Equity value  Firm value  Market value of debt (4-2)

Dividing the total value of equity by the number of outstanding shares gives the value
per share.

1
Adjustments for excess cash and marketable securities and for other nonoperating assets are discussed
further in Section 5. Excess means excess in relation to operating needs.
2
The adjusted present value (APV) approach is one example of such models. In the APV approach,
firm value is calculated as the sum of (1) the value of the company under the assumption that debt is
not used (i.e., unlevered firm value) and (2) the net present value of any effects of debt on firm value
(such as any tax benefits of using debt and any costs of financial distress). In this approach, the analyst
estimates unlevered company value by discounting FCFF (under the assumption of no debt) at the
unlevered cost of equity (the cost of equity given that the firm does not use debt). For details, see Ross,
Westerfield, and Jaffe (2005), who explain APV in a capital budgeting context.

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 Chapter 4 Free Cash Flow Valuation 149

The cost of capital is the required rate of return that investors should demand for a cash
flow stream like that generated by the company being analyzed. WACC depends on the
riskiness of these cash flows. The calculation and interpretation of WACC were discussed in
Chapter 2—that is, WACC is the weighted average of the after (corporate) tax required rates
of return for debt and equity, where the weights are the proportions of the firm’s total market
value from each source, debt and equity. As an alternative, analysts may use the weights of
debt and equity in the firm’s target capital structure when those weights are known and differ
from market value weights. The formula for WACC is
MV(Debt) MV(Equity)
WACC  rd (1 Tax rate)  r (4-3)
MV(Debt)  MV(Equity) MV(Debt)  MV(Equity)
MV(Debt) and MV(Equity) are the current market values of debt and equity, not their book
or accounting values, and the ratios of MV(Debt) and MV(Equity) to the total market value of
debt plus equity define the weights in the WACC formula. The quantities rd (1 – Tax rate) and
r are, respectively, the after-tax cost of debt and the after-tax cost of equity (in the case of equity,
one could just write “cost of equity” because net income, the income belonging to equity, is after
tax). In Equation 4-3, the tax rate is in principle the marginal corporate income tax rate.

2.2.2. Present Value of FCFE

The value of equity can also be found by discounting FCFE at the required rate of return on
equity, r:
∞
FCFEt
Equity value  ∑ (4-4)
t 1 (1 r )t
Because FCFE is the cash flow remaining for equity holders after all other claims have
been satisfied, discounting FCFE by r (the required rate of return on equity) gives the value
of the firm’s equity. Dividing the total value of equity by the number of outstanding shares
gives the value per share.

2.3. Single-Stage (Constant-Growth) FCFF and FCFE Models

In the DDM approach, the Gordon (constant- or stable-growth) model makes the assump-
tion that dividends grow at a constant rate. The assumption that free cash flows grow at a
constant rate leads to a single-stage (stable-growth) FCFF or FCFE model.3

2.3.1. Constant-Growth FCFF Valuation Model

Assume that FCFF grows at a constant rate, g, such that FCFF in any period is equal to
FCFF in the previous period multiplied by (1  g):
FCFFt  FCFFt1(1  g )
If FCFF grows at a constant rate,
FCFF1 FCFF0 (1 g )
Firm value   (4-5)
WACC  g WACC  g
Subtracting the market value of debt from the firm value gives the value of equity.

3
In the context of private company valuation, these constant-growth free cash flow models are often
referred to as capitalized cash flow models.

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 150 Equity Asset Valuation

EXAMPLE 4-1 Using the Constant-Growth FCFF

Valuation Model

Cagiati Enterprises has FCFF of 700 million Swiss francs (CHF) and FCFE of
CHF620 million. Cagiati’s before-tax cost of debt is 5.7 percent, and its required
rate of return for equity is 11.8 percent. The company expects a target capital struc-
ture consisting of 20 percent debt financing and 80 percent equity financing. The tax
rate is 33.33 percent, and FCFF is expected to grow forever at 5.0 percent. Cagiati
Enterprises has debt outstanding with a market value of CHF2.2 billion and has 200
million outstanding common shares.

1. What is Cagiati’s weighted average cost of capital?

2. What is the value of Cagiati’s equity using the FCFF valuation approach?
3. What is the value per share using this FCFF approach?

Solution to 1: From Equation 4-3, WACC is

WACC  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 dis-
counted by using WACC. For FCFF growing at a constant 5 percent rate, the result is
FCFF1 FCFF0 (1 g ) 700(1.05) 735
Firm value    
WACC  g WACC  g 0.102  0.05 0.052
 CHF14, 134.6 million

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 CHF11,934.6 million by the number of outstanding shares
gives the estimated value per share, V0:
V0  CHF11,934.6 million/200 million shares  CHF59.67 per share

2.3.2. Constant-Growth FCFE Valuation Model

The constant-growth FCFE valuation model assumes that FCFE grows at constant rate g.
FCFE in any period is equal to FCFE in the preceding period multiplied by (1  g):
FCFEt  FCFEt1(1 g )
The value of equity if FCFE is growing at a constant rate is
FCFE1 FCFE 0 (1  g )
Equity value   (4-6)
rg rg
The discount rate is r, the required rate of return on equity. Note that the growth rate of
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 valuation and the
simplest implementation, single-stage free cash flow models. The next section examines the pre-
cise definition of free cash flow and introduces the issues involved in forecasting free cash flow.

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 Chapter 4 Free Cash Flow Valuation 151

3. FORECASTING FREE CASH FLOW

Estimating FCFF or FCFE requires a complete understanding of the company and its finan-
cial statements. To provide a context for the estimation of FCFF and FCFE, we first use an
extensive example to show the relationship between free cash flow and accounting 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 for a company
financed by using only debt and common stock, it is easy to incorporate preferred stock for
the relatively small number of companies that actually use it (in Section 3.8 we incorporate
preferred stock as a third source of capital).

3.1. Computing FCFF from Net Income

FCFF is the cash flow available to the company’s suppliers of capital after all operating
expenses (including taxes) have been paid and operating investments have been made. The
company’s suppliers of capital include bondholders and common shareholders (plus, occa-
sionally, holders of preferred stock, which we ignore until later). Keeping in mind that a non-
cash charge is a charge or expense that does not involve the outlay of cash, we can write the
expression for FCFF as follows:

FCFF  Net income available to common shareholders (NI)

Plus: Net noncash charges (NCC)
Plus: Interest expense  (1 – Tax rate)
Less: Investment in fixed capital4 (FCInv)
Less: Investment in working capital (WCInv)

This equation can be written more compactly as

FCFF  NI  NCC  Int(1  Tax rate)  FCInv  WCInv (4-7)
Consider each component of FCFF. The starting point in Equation 4-7 is net income
available to common shareholders—the bottom line in an income statement. It represents
income after depreciation, amortization, interest expense, income taxes, and the payment of
dividends to preferred shareholders (but not payment of dividends to common shareholders).
Net noncash charges represent an adjustment for noncash decreases and increases in net
income. This adjustment is the first of several that analysts generally perform on a net basis. If
noncash decreases in net income exceed the increases, as is usually the case, the adjustment is
positive. If noncash increases exceed noncash decreases, the adjustment is negative. The most
common noncash charge is depreciation expense. When a company purchases fixed capital,
such as equipment, the balance sheet reflects a cash outflow at the time of the purchase. In sub-
sequent periods, the company records depreciation expense as the asset is used. The depreciation
expense reduces net income but is not a cash outflow. Depreciation expense is thus one (the
most common) noncash charge that must be added back in computing FCFF. In the case of

4
In this chapter, when we refer to “investment in fixed capital” or “investment in working capital,”
we are referring to the investments made in the specific period for which the free cash flow is being
calculated.

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 152 Equity Asset Valuation

intangible assets, there is a similar noncash charge, amortization expense, which must be added
back. Other noncash charges vary from company to company and are discussed in Section 3.3.
After-tax interest expense must be added back to net income to arrive at FCFF. This step
is required because interest expense net of the related tax savings was deducted in arriving at
net income and because interest is a cash flow available to one of the company’s capital pro-
viders (i.e., the company’s creditors). In the United States and many other countries, interest
is tax deductible (reduces taxes) for the company (borrower) and taxable for the recipient
(lender). As we explain later, when we discount FCFF, we use an after-tax cost of capital. For
consistency, we thus compute FCFF by using the after-tax interest paid.5
Similar to after-tax interest expense, if a company has preferred stock, dividends on that
preferred stock are deducted in arriving at net income available to common shareholders.
Because preferred stock dividends are also a cash flow available to one of the company’s capi-
tal providers, this item is added back to arrive at FCFF. Further discussion of the effects of
preferred stock is in Section 3.8.
Investments in fixed capital represent the outflows of cash to purchase fixed capital
necessary to support the company’s current and future operations. These investments are cap-
ital expenditures for long-term assets, such as the property, plant, and equipment (PP&E)
necessary to support the company’s operations. Necessary capital expenditures may also
include intangible assets, such as trademarks. In the case of cash acquisition of another com-
pany instead of a direct acquisition of PP&E, the cash purchase amount can also be treated
as a capital expenditure that reduces the company’s free cash flow (note that this treatment
is conservative because it reduces FCFF). In the case of large acquisitions (and all noncash
acquisitions), analysts must take care in evaluating the impact on future free cash flow. If a
company receives cash in disposing of any of its fixed capital, the analyst must deduct this
cash in calculating investment in fixed capital. For example, suppose we had a sale of equip-
ment for $100,000. This cash inflow would reduce the company’s cash outflows for invest-
ments in fixed capital.
The company’s cash flow statement is an excellent source of information on capital
expenditures as well as on sales of fixed capital. Analysts should be aware that some compa-
nies acquire fixed capital without using cash—for example, through an exchange for stock
or debt. Such acquisitions do not appear in a company’s cash flow statement but, if mate-
rial, must be disclosed in the footnotes. Although noncash exchanges do not affect historical
FCFF, if the capital expenditures are necessary and may be made in cash in the future, the
analyst should use this information in forecasting future FCFF.
The final point to cover is the important adjustment for net increases in working capital.
This adjustment represents the net investment in current assets (such as accounts receivable)
less current liabilities (such as accounts payable). Analysts can find this information by exam-
ining either the company’s balance sheet or its cash flow statement.
Although working capital is often defined as current assets minus current liabilities,
working capital for cash flow and valuation purposes is defined to exclude cash and short-
term debt (which includes notes payable and the current portion of long-term debt). When
finding the net increase in working capital for the purpose of calculating free cash flow, we
define working capital to exclude cash and cash equivalents as well as notes payable and the
current portion of long-term debt. Cash and cash equivalents are excluded because a change

5
Note that we could compute WACC on a pretax basis and compute FCFF by adding back interest
paid with no tax adjustment. Whichever approach is adopted, the analyst must use mutually consistent
definitions of FCFF and WACC.

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 Chapter 4 Free Cash Flow Valuation 153

in cash is what we are trying to explain. Notes payable and the current portion of long-term
debt are excluded because they are liabilities with explicit interest costs that make them
financing items rather than operating items.
Example 4-2 shows all of the adjustments to net income required to find FCFF.

EXAMPLE 4-2 Calculating FCFF from Net Income

Cane Distribution, Inc., incorporated on 31 December 2007 with initial capital infusions
of $224,000 of debt and $336,000 of common stock, acts as a distributor of industrial
goods. The company managers immediately invested the initial capital in fixed capital of
$500,000 and working capital of $60,000. Working capital initially consisted solely of
inventory. The fixed capital consisted of nondepreciable property of $50,000 and deprecia-
ble property of $450,000. The depreciable property has a 10-year useful life with no salvage
value. Exhibits 4-1, 4-2, and 4-3 provide Cane’s financial statements for the three years fol-
lowing incorporation. Starting with net income, calculate Cane’s FCFF for each year.

EXHIBIT 4-1 Cane Distribution, Inc. Income Statement (in thousands)

Years Ending 31 December
2008 2009 2010
Earnings before interest, taxes, depreciation,
and amortization (EBITDA) $200.00 $220.00 $242.00
Depreciation expense 45.00 49.50 54.45
Operating income 155.00 170.50 187.55
Interest expense (at 7 percent) 15.68 17.25 8.97
Income before taxes 139.32 153.25 168.58
Income taxes (at 30 percent) 41.80 45.97 50.58
Net income $97.52 $107.28 $118.00

EXHIBIT 4-2 Cane Distribution, Inc. Balance Sheet (in thousands)

Years Ending 31 December
2007 2008 2009 2010

Cash $ 0.00 $108.92 $228.74 $360.54

Accounts receivable 0.00 100.00 110.00 121.00
Inventory 60.00 66.00 72.60 79.86
Current assets 60.00 274.92 411.34 561.40
Fixed assets 500.00 500.00 550.00 605.00
Less: Accumulated depreciation 0.00 45.00 94.50 148.95
Total assets $560.00 $729.92 $866.84 $1,017.45

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 154 Equity Asset Valuation

Accounts payable $ 0.00 $ 50.00 $ 55.00 $ 60.50

Current portion of long-term debt 0.00 0.00 0.00 0.00
Current liabilities 0.00 50.00 55.00 60.50

Long-term debt 224.00 246.40 271.04 298.14

Common stock 336.00 336.00 336.00 336.00

Retained earnings 0.00 97.52 204.80 322.80

Total liabilities and equity $560.00 $729.92 $866.84 $1,017.45

EXHIBIT 4-3 Cane Distribution, Inc. Working Capital (in thousands)

Years Ending 31 December
2007 2008 2009 2010

Current assets excluding cash

Accounts receivable $ 0.00 $100.00 $110.00 $121.00
Inventory 60.00 66.00 72.60 79.86
Total current assets excluding cash 60.00 166.00 182.60 200.86

Current liabilities excluding

short-term debt
Accounts payable 0.00 50.00 55.00 60.50

Working capital $60.00 $116.00 $127.60 $140.36

Increase in working capital $56.00 $11.60 $12.76

Solution: Following the logic in Equation 4-7, we calculate FCFF from net income as
follows: We add noncash charges (here, depreciation) and after-tax interest expense
to net income, then subtract the investment in fixed capital and the investment in
working capital. The format for presenting the solution follows the convention that
parentheses around a number indicate subtraction. The calculation follows (in thou-
sands):

Years Ending 31 December

2008 2009 2010
Net income $97.52 $107.28 $118.00
Noncash charges – Depreciation 45.00 49.50 54.45
Interest expense  (1 – Tax rate) 10.98 12.08 13.28
Investment in fixed capital (0.00) (50.00) (55.00)
Investment in working capital (56.00) (11.60) (12.76)
Free cash flow to the firm $97.50 $107.26 $117.97

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 Chapter 4 Free Cash Flow Valuation 155

3.2. Computing FCFF from the Statement of Cash Flows

FCFF is cash flow available to all providers of capital (debt and equity). Analysts frequently
use cash flow from operations, taken from the statement of cash flows, as a starting point to
compute free cash flow because CFO incorporates adjustments for noncash expenses (such as
depreciation and amortization) as well as for net investments in working capital.
In a statement of cash flows, cash flows are separated into three components: cash flow from
operating activities (or cash flow from operations), cash flow from investing activities, and cash
flow from financing activities. Cash flow from operations is the net amount of cash provided by
the company’s operating activities. The operating section of the cash flow statement shows such
cash flows as cash received from customers and cash paid to suppliers. Cash flow from investing
activities includes the company’s investments in (or sales of) long-term assets—for example, PP&E
and long-term investments in other companies. Cash flow from financing activities relates to the
company’s activities in raising or repaying capital. International Financial Reporting Standards
(IFRS) allow the company to classify interest paid as either an operating or financing activity.
Furthermore, IFRS allow dividends paid to be classified as either an operating or financing activity.
Interestingly, under U.S. generally accepted accounting principles (GAAP), interest expense paid
to providers of debt capital must be classified as part of cash flow from operations (as is interest
income) but payment of dividends to providers of equity capital is classified as a financing activity.
Exhibit 4-4 summarizes IFRS and U.S. GAAP treatment of interest and dividends.
EXHIBIT 4-4 IFRS versus U.S. GAAP Treatment of Interest and Dividends
IFRS U.S. GAAP
Interest received Operating or Investing Operating
Interest paid Operating or Financing Operating
Dividends received Operating or Investing Operating
Dividends paid Operating or Financing Financing

To estimate FCFF by starting with CFO, we must recognize the treatment of interest paid.
If the after-tax interest expense was taken out of net income and out of CFO, as with U.S. GAAP,
then after-tax interest expense must be added back to get FCFF. In the case of U.S. GAAP, FCFF
can be estimated as follows:
Free cash flow to the firm  Cash flow from operations
Plus: Interest expense  (1 – Tax rate)
Less: Investment in fixed capital
or
FCFF  CFO  Int(1  Tax rate)  FCInv (4-8)
To reiterate, the after-tax interest expense is added back because it was previously taken
out of net income. The investment in working capital does not appear in Equation 4-8
because CFO already includes investment in working capital. Example 4-3 illustrates the use
of CFO to calculate FCFF. In this example, the calculation of CFO begins with calculating
net income, an approach known as the indirect method.6
6
See Robinson, van Greuning, Henry, and Broihahn (2009b) for a discussion of the indirect and direct
cash flow statement formats.

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 156 Equity Asset Valuation

EXAMPLE 4-3 Calculating FCFF from CFO

Use the information from the statement of cash flows given in Exhibit 4-5 to calcu-
late FCFF for the three years 2008–2010. The tax rate (as given in Exhibit 4-1) is 30
percent.

EXHIBIT 4-5 Cane Distribution, Inc. Statement of Cash Flows: Indirect Method (in thousands)
Years Ending 31 December
2008 2009 2010
Cash flow from operations
Net income $97.52 $107.28 $118.00
Plus: Depreciation 45.00 49.50 54.45
Increase in accounts receivable (100.00) (10.00) (11.00)
Increase in inventory (6.00) (6.60) (7.26)
Increase in accounts payable 50.00 5.00 5.50
Cash flow from operations 86.52 145.18 159.69
Cash flow from investing activities
Purchases of PP&E 0.00 (50.00) (55.00)
Cash flow from financing activities
Borrowing (repayment) 22.40 24.64 27.10
Total cash flow 108.92 119.82 131.80
Beginning cash 0.00 108.92 228.74
Ending cash $108.92 $228.74 $360.54
Notes:
Cash paid for interest ($15.68) ($17.25) ($18.97)
Cash paid for taxes ($41.80) ($45.98) ($50.57)

Solution: As shown in Equation 4-8, FCFF equals CFO plus after-tax interest minus
the investment in fixed capital:

Years Ending 31 December

2008 2009 2010
Cash flow from operations $86.52 $145.18 $159.69
Interest expense  (1 – Tax rate) 10.98 12.08 13.28
Investment in fixed capital (0.00) (50.00) (55.00)
Free cash flow to the firm $97.50 $107.26 $117.97

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 Chapter 4 Free Cash Flow Valuation 157

3.3. Noncash Charges

The best place to find historical noncash charges is in the company’s statement of cash flows. If
an analyst wants to use an add-back method, as in FCFF  NI  NCC  Int(1 – Tax rate) –
FCInv – WCInv, the analyst should verify the noncash charges to ensure that the FCFF
estimate provides a reasonable basis for forecasting. For example, restructuring charges may
involve cash expenditures and noncash charges. Severance pay for laid-off employees could be
a cash restructuring charge, but a write-down in the value of assets as part of a restructuring
charge is a noncash item. Example 4-4 illustrates noncash restructuring charges that must be
added back to net income to obtain CFO. Note in the example that (noncash) gains from
the sale of assets in restructuring are subtracted from net income to obtain CFO.

EXAMPLE 4-4 An Examination of Noncash Charges

Alberto-Culver Company (NYSE: ACV) develops, manufactures, distributes, and markets

branded beauty care products and branded food and household products in more than 100
countries. Jane Everett wants to value Alberto-Culver by using the FCFF method. She col-
lects information from the company’s 10-K for the fiscal year ended 30 September 2007.
Note that the cash flow statement in Exhibit 4-6 uses a presentation convention that
follows the logic that “minus a minus equals a plus,” so in this convention, “Less: . . . 50”
means “subtract 50” and “Less: . . . (50)” means “add 50.” An analyst may also encounter
in practice, however, “Less: . . . (50)” interpreted as “subtract 50.”
EXHIBIT 4-6 Consolidated Statements of Cash Flows Alberto-Culver Company
and Subsidiaries (in US$ thousands)

2007 2006 2005

Cash Flows from Operating Activities:
Net earnings 78,264 205,321 210,901
Less: Earnings (loss) from discontinued
operations (2,963) 125,806 141,062
Earnings from continuing operations 81,227 79,515 69,839
Adjustments to reconcile earnings from
continuing operations to net cash
provided by operating activities:
Depreciation 28,824 24,642 23,420
Amortization of other assets
and unearned compensation 2,811 3,403 2,774
Restructuring and other noncash charges 14,053 — —
Restructuring and other—gain on sale
of assets (5,894) — —
Noncash charge related to conversion
to one class of common stock — 4 10,456
Stock option expense 3,741 10,763 —
Deferred income taxes (21,064) 2,196 677

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 158 Equity Asset Valuation

Cash effects of changes in (excluding acquisitions and divestitures):

Receivables, net (26,635) (15,270) (24,223)
Inventories 4,168 (13,424) (13,751)
Other current assets 2,842 (5,497) (1,665)
Accounts payable and accrued expenses 15,096 4,761 (14,386)
Income taxes 4,657 (905) 9,137
Other assets (897) (2,786) (8,595)
Other liabilities (3,914) 3,736 15,192
Net cash provided by operating activities 99,015 91,138 68,875

Everett notices that the reconciliation amounts in the cash flow statement for
restructuring charges differ from the $34,645 restructuring charge recorded in the
income statement. She finds the following discussion of restructuring charges in
the management discussion and analysis (MD&A) section (Exhibit 4-7).

EXHIBIT 4-7 Excerpt from Management Discussion and Analysis

Restructuring and other expenses during the fiscal year ended September 30,
2007 consist of the following (in thousands):
Severance and other exit costs $17,056
Noncash charges related to the acceleration of vesting of stock options 12,198
and restricted shares in connection with the separation
Contractual termination benefits for the former president and chief 9,888
executive officer in connection with the separation
Noncash charge for the recognition of foreign currency translation loss in 1,355
connection with the liquidation of a foreign legal entity
Legal fees and other expenses incurred to assign the company’s trademarks 42
following the closing of the separation
Gain on sale of assets (5,894)

$34,645

Severance and Other Exit Costs

On November 27, 2006, the company committed to a plan to terminate employees as part
of a reorganization following the separation. In connection with this reorganization plan,
on December 1, 2006 the company announced that it expects to close its manufacturing
facility in Dallas, Texas. The company’s worldwide workforce is being reduced by approxi-
mately 225 employees as a result of the reorganization plan, including 125 employees from
the Dallas, Texas manufacturing facility. The changes primarily affect corporate functions
or the Consumer Packaged Goods business segment. The company expects to record addi-
tional pre-tax restructuring charges of approximately $1.5 million related to this plan in
fiscal year 2008, primarily during the first half. These amounts exclude the effect of the
sale of the manufacturing facility in Dallas, Texas. Cash payments related to this plan are
expected to be substantially completed by the end of the second quarter of fiscal year 2008.

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 Chapter 4 Free Cash Flow Valuation 159

The following table reflects the activity related to the restructuring plan during the
fiscal year ended September 30, 2007 (in thousands):

Cash Payments & Liability at

Initial Charges Other Settlements September 30, 2007

Severance $15,405 (12,774) 2,631

Contract
termination costs 237 (237) —
Other 1,414 (1,321) 93
$17,056 (14,332) 2,724

Using the information about Alberto-Culver provided, answer the following questions:

1. Why is there a difference in the amount shown for restructuring charges in the
income statement and the amount shown for restructuring charges in the cash
flow statement?
2. How should the restructuring charges be treated when forecasting future cash
flows?

Solution to 1: The difference between restructuring charges in the income statement

and restructuring charges in the cash flow statement arises because some of the restruc-
turing charges were paid in cash and others were not. The cash flow statement shows
the noncash restructuring charges ($14,053) as an amount added back to net income
in the process of arriving at net cash provided by operating activities.
Note that Exhibit 4-7 discloses two noncash charges, which total $12,198 
$1,355  $13,553, but the statement of cash flows shows restructuring and other
noncash charges of $14,053. The MD&A provides no explanation for the balance
of $14,053 – $13,553  $500; thus, the MD&A disclosure of information is
incomplete.
Solution to 2: Restructuring charges are generally unpredictable and are not typically
part of a forecast. In Alberto-Culver’s case, however, $2,724 of restructuring-related
liabilities remain (consisting mostly of liabilities for severance pay), which the com-
pany expects to pay in early 2008. Therefore, the forecast for 2008 should reflect these
cash expenditures that will be made.

Noncash restructuring charges may also cause an increase in net income in some cir-
cumstances—for example, when a company reverses part or all of a previous accrual. Gains
and losses (e.g., of operating assets) are another noncash item that may increase or decrease
net noncash charges. If a company sells a piece of equipment with a book value of €60,000
for €100,000, it reports the €40,000 gain as part of net income. The €40,000 gain is not a
cash flow, however, and must be subtracted in arriving at FCFF. Note that the €100,000 is
a cash flow and is part of the company’s net investment in fixed capital. A loss reduces net

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 160 Equity Asset Valuation

income and thus must be added back in arriving at FCFF. Aside from depreciation, gains
and losses are the most commonly seen noncash charges that require an adjustment to net
income. Analysts should examine the company’s cash flow statement to identify items par-
ticular to a company and to determine what adjustments the analyst might need to make for
the accounting numbers to be useful for forecasting purposes.
Exhibit 4-8 summarizes the common noncash charges that affect net income and indi-
cates for each item whether to add it to or subtract it from net income in arriving at FCFF.

EXHIBIT 4-8 Noncash Items and FCFF

Noncash Item Adjustment to NI to Arrive at FCFF
Depreciation Added back
Amortization and impairment of intangibles Added back
Restructuring charges (expense) Added back
Restructuring charges (income resulting from
reversal) Subtracted
Losses Added back
Gains Subtracted
Amortization of long-term bond discounts Added back
Amortization of long-term bond premiums Subtracted
Deferred taxes Added back but calls for special attention

The item “Deferred taxes” requires special attention because deferred taxes result from
differences in the timing of reporting income and expenses in the company’s financial state-
ments and the company’s tax return. The income tax expense deducted in arriving at net
income for financial reporting purposes is not the same as the amount of cash taxes paid.
Over time, these differences between book income and taxable income should offset each
other and have no impact on aggregate cash flows. Generally, if the analyst’s purpose is
forecasting and, therefore, identifying the persistent components of FCFF, then the analyst
should not add back deferred tax changes that are expected to reverse in the near future.
In some circumstances, however, a company may be able to consistently defer taxes until a
much later date. If a company is growing and has the ability to indefinitely defer its tax liabil-
ity, adding back deferred taxes to net income is warranted. Nevertheless, an acquirer must be
aware that these taxes may be payable at some time in the future.
Companies often record expenses (e.g., restructuring charges) for financial reporting pur-
poses that are not deductible for tax purposes. In this case, current tax payments are higher
than taxes reported in the income statement, resulting in a deferred tax asset and a subtrac-
tion from net income to arrive at cash flow in the cash flow statement. If the deferred tax
asset is expected to reverse in the near future (e.g., through tax depreciation deductions), to
avoid underestimating future cash flows, the analyst should not subtract the deferred tax asset
in a cash flow forecast. If the company is expected to have these charges on a continual basis,
however, a subtraction that will lower the forecast of future cash flows is warranted.
Employee share-based compensation (stock options) provides another challenge to the
forecaster. Under IFRS and U.S. GAAP, companies must record in the income statement

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 Chapter 4 Free Cash Flow Valuation 161

an expense for options provided to employees. The granting of options themselves does not
result in a cash outflow and is thus a noncash charge; however, the granting of options has
long-term cash flow implications. When the employee exercises the option, the company
receives some cash related to the exercise price of the option at the strike price. This cash
flow is considered a financing cash flow. Also, in some cases, a company receives a tax benefit
from issuing options, which could increase operating cash flow but not net income. Both
IFRS and U.S. GAAP require that a portion of the tax effect be recorded as a financing cash
flow rather than an operating cash flow in the cash flow statement. Analysts should review
the cash flow statement and footnotes to determine the impact of options on operating
cash flows. If these cash flows are not expected to persist in the future, analysts should not
include them in their forecasts of cash flows. Analysts should also consider the impact of
stock options on the number of shares outstanding. When computing equity value, analysts
may want to use the number of shares expected to be outstanding (based on the exercise of
employee stock options) rather than the number currently outstanding.
Example 4-5 illustrates that when forecasting cash flows for valuation purposes, analysts
should consider the sustainability of historical working capital effects on free cash flow.

EXAMPLE 4-5 Sustainability of Working Capital Effects

on Free Cash Flow

Ryanair Holdings PLC (LSE: RYAOF) operates a low-fares scheduled passenger air-
line serving short-haul, point-to-point routes between Ireland, the United Kingdom,
Continental Europe, and Morocco. The operating activities section of its cash flow
statement and a portion of the investing activities section are presented in Exhibit 4-9.
The cash flow statement was prepared in accordance with IFRS.

EXHIBIT 4-9 Ryan Holdings PLC Excerpt from Cash Flow Statement (euro in thousands)
Year Ended 31 March
2007 2006 2005
Operating activities
Profit before tax 451,037 338,888 309,196

Adjustments to reconcile profits before tax

to net cash provided by operating activities
Depreciation 143,503 124,405 110,357
Decrease (increase) in inventories 1,002 (962) (424)
Decrease (increase) in trade receivables 6,497 (9,265) (5,712)
Decrease (increase) in other current assets (30,849) (882) (4,855)
(Decrease) increase in trade payables (24,482) (12,835) 24,182
(Decrease) increase in accrued expenses 233,839 150,083 89,406

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 162 Equity Asset Valuation

(Decrease) increase in other creditors 75,351 11,403 (10,986)

Increase in maintenance provisions 11,997 9,486 714
Loss (gain) on disposal of property, plant,
and equipment (91) (815) (47)
Decrease (increase) in interest receivable 48 (3,959) (505)
(Decrease) increase in interest payable 2,671 1,159 3,420
Retirement costs 589 507 167
Share-based payments 3,935 2,921 488
Income tax (5,194) 436 (4,198)

Net cash provided by operating activities 869,853 610,570 511,203

Investing activities
Capital expenditure (purchase of property,
plant, and equipment) (494,972) (546,225) (631,994)

Analysts predict that as Ryanair grows in coming years, depreciation expense will
increase substantially.
Based on the information given, address the following:

1. Contrast reported depreciation expense to reported capital expenditures and

describe the implications of future growth in depreciation expense (all else being
equal) for future net income and future cash from operating activities.
2. Explain the effects on free cash flow to equity of changes in 2007 in working capital
accounts, such as inventory, accounts receivable, and accounts payable, and com-
ment on the long-term sustainability of such changes.

Solution to 1: In the 2005–2007 period, depreciation expense was a small fraction of

capital expenditures. For example, in 2007, capital expenditures of €495 million were
3.5 times as large as the €143.5 million depreciation expense.
In calculating net income, depreciation is a deduction. Therefore, as depreciation
expense increases in coming years, net income will decrease. Specifically, net income will
be reduced by (Depreciation expense)  (1 – Tax rate). In calculating CFO, however,
depreciation is added back in full to net income. The difference between depreciation
expense—the amount added back to net income to calculate CFO—and the amount
by which net income is reduced by depreciation expense is (Tax rate)  (Depreciation
expense), which represents a positive increment to CFO. Thus, the projected increase in
depreciation expense is a negative for future net income but a positive for future CFO.
(At worst, if the company operates at a loss, depreciation is neutral for CFO.)
Solution to 2: In 2007, the decreases in inventory and accounts receivable (“trade
receivables”) resulted in positive adjustments to net income (i.e., the changes increased
cash flow relative to net income). The adjustments are positive because decreases in
these accounts (the sale of inventory and collection of accounts receivable) are a source

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 Chapter 4 Free Cash Flow Valuation 163

of cash. On the current liabilities side, the increase in accrued expenses and increase
in “other creditors” are also added back to net income and are sources of cash because
such increases represent increased amounts for which cash payments have yet to
be made. The negative adjustment for accounts payable, however, indicates that the
accounts payable balance declined in 2007: Ryanair spent cash to reduce the amount
of trade credit being extended to it by suppliers during the year, resulting in a reduc-
tion in cash. Because CFO is a component of FCFE, the items that had a positive
(negative) effect on CFO also have a positive (negative) effect on FCFE.
Declining balances for assets, such as inventory, or for liabilities, such as accounts
payable, are not sustainable indefinitely. In the extreme case, the balance declines to
zero and no further reduction is possible. Given the growth in its net income and the
expansion of PP&E evidenced by capital expenditures, Ryanair appears to be grow-
ing and investors should expect its working capital requirements to grow accordingly.
Thus, the components of 2007 FCFE attributable to reduction in inventory and
accounts receivable balances are probably not relevant in forecasting future FCFE.

3.4. Computing FCFE from FCFF

FCFE is cash flow available to equity holders only. To find FCFE, therefore, we must reduce
FCFF by the after-tax value of interest paid to debt holders and add net borrowing (which is
debt issued less debt repaid over the period for which one is calculating free cash flow):

Free cash flow to equity  Free cash flow to the firm

Less: Interest expense  (1 – Tax rate)
Plus: Net borrowing

or
FCFE  FCFF  Int(1  Tax rate)  Net borrowing (4-9)
As Equation 4-9 shows, FCFE is found by starting from FCFF, subtracting after-tax
interest expenses, and adding net new borrowing. The analyst can also find FCFF from FCFE
by making the opposite adjustments—by adding after-tax interest expenses and subtracting
net borrowing: FCFF  FCFE  Int(1 – Tax rate) – Net borrowing.
Exhibit 4-10 uses the values for FCFF for Cane Distribution calculated in Example
4-3 to show the calculation of FCFE when starting with FCFF. To calculate FCFE in this

EXHIBIT 4-10 Calculating FCFE from FCFF

Years Ending 31 December

2008 2009 2010
Free cash flow to the firm 97.50 107.26 117.97
Interest paid  (1 – Tax rate) (10.98) (12.08) (13.28)
New debt borrowing 22.40 24.64 27.10
Debt repayment (0) (0) (0)
Free cash flow to equity 108.92 119.82 131.79

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 164 Equity Asset Valuation

manner, we subtract after-tax interest expense from FCFF and then add net borrowing (equal
to new debt borrowing minus debt repayment).
To reiterate, FCFE is the cash flow available to common stockholders—the cash flow
remaining after all operating expenses (including taxes) have been paid, capital investments
have been made, and other transactions with other suppliers of capital have been carried out.
The company’s other capital suppliers include creditors, such as bondholders, and preferred
stockholders. The cash flows (net of taxes) that arise from transactions with creditors and pre-
ferred stockholders are deducted from FCFF to arrive at FCFE.
FCFE is the amount that the company can afford to pay out as dividends. In actual-
ity, for various reasons companies often pay out substantially more or substantially less than
FCFE, so FCFE often differs from dividends paid. One reason for this difference is that the
dividend decision is a discretionary decision of the board of directors. Most corporations
manage their dividends; they prefer to raise them gradually over time, partly because they do
not want to have to cut dividends. Many companies raise dividends slowly even when their
earnings are increasing rapidly, and companies often maintain their current dividends even
when their profitability has declined. Consequently, earnings are much more volatile than
dividends.
In Equations 4-7 and 4-8, we show the calculation of FCFF starting with, respectively, net
income and cash flow from operations. As Equation 4-9 shows, FCFE  FCFF – Int(1 – Tax
rate)  Net borrowing. By subtracting after-tax interest expense and adding net borrowing to
Equations 4-7 and 4-8, we have equations to calculate FCFE starting with, respectively, net
income and CFO:
FCFE  NI  NCC – FCInv – WCInv  Net borrowing (4-10)

FCFE  CFO – FCInv  Net borrowing (4-11)

Example 4-6 illustrates how to adjust net income or CFO to find FCFF and FCFE.

EXAMPLE 4-6 Adjusting Net Income or CFO to Find FCFF

and FCFE

The balance sheet, income statement, and statement of cash flows for the Pitts
Corporation are shown in Exhibit 4-11. Note that the statement of cash flows
follows a convention according to which the positive numbers of $400 million
and $85 million for “cash used for investing activities” and “cash used for financ-
ing activities,” respectively, indicate outflows and thus amounts to be subtracted.
Analysts will also encounter a convention in which the value “(400)” for “cash pro-
vided by (used for) investing activities” would be used to indicate a subtraction of
$400.

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 Chapter 4 Free Cash Flow Valuation 165

EXHIBIT 4-11 Financial Statements for Pitts Corporation (in millions, except for
per-share data)
Balance Sheet
Year Ended 31 December
2006 2007
Assets
Current assets
Cash and equivalents $190 $200
Accounts receivable 560 600
Inventory 410 440
Total current assets 1,160 1,240
Gross fixed assets 2,200 2,600
Accumulated depreciation (900) (1,200)
Net fixed assets 1,300 1,400
Total assets $2,460 $2,640
Liabilities and shareholders’ equity
Current liabilities
Accounts payable $285 $300
Notes payable 200 250
Accrued taxes and expenses 140 150
Total current liabilities 625 700
Long-term debt 865 890
Common stock 100 100
Additional paid-in capital 200 200
Retained earnings 670 750
Total shareholders’ equity 970 1,050
Total liabilities and shareholders’ equity $2,460 $2,640
Statement of Income
Year Ended 31 December 2007
Total revenues $3,000
Operating costs and expenses 2,200
EBITDA 800
Depreciation 300
Operating income (EBIT) 500
Interest expense 100
Income before tax 400

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 166 Equity Asset Valuation

Taxes (at 40 percent) 160

Net income 240
Dividends 160
Change in retained earnings 80
Earnings per share (EPS) $0.48
Dividends per share $0.32
Statement of Cash Flows
Year Ended 31 December 2007
Operating activities
Net income $240
Adjustments
Depreciation 300
Changes in working capital
Accounts receivable (40)
Inventories (30)
Accounts payable 15
Accrued taxes and expenses 10
Cash provided by operating activities $495
Investing activities
Purchases of fixed assets 400
Cash used for investing activities $400
Financing activities
Notes payable (50)
Long-term financing issuances (25)
Common stock dividends 160
Cash used for financing activities $85
Cash and equivalents increase (decrease) 10
Cash and equivalents at beginning of year 190
Cash and equivalents at end of year $200
Supplemental cash flow disclosures
Interest paid $100
Income taxes paid $160

Note that the Pitts Corporation had net income of $240 million in 2007. In the fol-
lowing, show the calculations required to do each of the following:

1. Calculate FCFF starting with the net income figure.

2. Calculate FCFE starting from the FCFF calculated in question 1.

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 Chapter 4 Free Cash Flow Valuation 167

3. Calculate FCFE starting with the net income figure.

4. Calculate FCFF starting with CFO.
5. Calculate FCFE starting with CFO.
Solution to 1: The analyst can use Equation 4-7 to find FCFF from net income
(amounts are in millions).

Net income available to common shareholders $240

Plus: Net noncash charges 300
Plus: Interest expense  (1 – Tax rate) 60
Less: Investment in fixed capital 400
Less: Investment in working capital 45
Free cash flow to the firm $155

In the format shown and throughout the solutions, “Less: . . . x” is interpreted as “sub-
tract x.”
This equation can also be written as
FCFF  NI  NCC  Int(1  Tax rate)  FCInv  WCInv
 240  300  60  400  45  $155 million
Some of these items need explanation. Capital spending is $400 million, which is the
increase in gross fixed assets shown on the balance sheet and in capital expenditures shown
as an investing activity in the statement of cash flows. The increase in working capital is
$45 million, which is the increase in accounts receivable of $40 million ($600 million 
$560 million) plus the increase in inventories of $30 million ($440 million  $410 mil-
lion) minus the increase in accounts payable of $15 million ($300 million  $285 million)
minus the increase in accrued taxes and expenses of $10 million ($150 million  $140
million). When finding the increase in working capital, we ignore cash because the change
in cash is what we are calculating. We also ignore short-term debt, such as notes payable,
because such debt is part of the capital provided to the company and is not considered an
operating item. The after-tax interest cost is the interest expense times (1  Tax rate): $100
million (1  0.40)  $60 million. The values of the remaining items in Equation 4-7 can
be taken directly from the financial statements.
Solution to 2: Finding FCFE from FCFF can be done with Equation 4-9.

Free cash flow to the firm $155

Less: Interest expense  (1 – Tax rate) 60
Plus: Net borrowing 75
Free cash flow to equity $170

Or by using the equation

FCFE  FCFF  Int(1  Tax rate)  Net borrowing
 155  60  75  $170 million

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 168 Equity Asset Valuation

Solution to 3: The analyst can use Equation 4-10 to find FCFE from NI.

Net income available to common shareholders $240

Plus: Net noncash charges 300
Less: Investment in fixed capital 400
Less: Investment in working capital 45
Plus: Net borrowing 75
Free cash flow to equity $170

Or by using the equation

FCFE  NI  NCC  FCInv  WCInv  Net borrowing
 240  300  400  45  75  $170 million
Because notes payable increased by $50 million ($250 million – $200 million) and
long-term debt increased by $25 million ($890 million – $865 million), net borrow-
ing is $75 million.

Solution to 4: Equation 4-8 can be used to find FCFF from CFO.

Cash flow from operations $495

Plus: Interest expense  (1 – Tax rate) 60
Less: Investment in fixed capital 400
Free cash flow to the firm $155

or
FCFF  CFO  Int(1  Tax rate)  FCInv
 495  60  400  $155 million.

Solution to 5: Equation 4-11 can be used to find FCFE from CFO.

Cash flow from operations $495

Less: Investment in fixed capital 400
Plus: Net borrowing 75
Free cash flow to equity $170

or
FCFE  CFO  FCInv  Net borrowing  495  400  75  $170 million.

FCFE is usually less than FCFF. In this example, however, FCFE ($170 million)
exceeds FCFF ($155 million) because external borrowing was large during this
year.

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 Chapter 4 Free Cash Flow Valuation 169

3.5. Finding FCFF and FCFE from EBIT or EBITDA

FCFF and FCFE are most frequently calculated from a starting basis of net income or CFO
(as shown in Sections 3.1 and 3.2). Two other starting points are EBIT and EBITDA from
the income statement.
To show the relationship between EBIT and FCFF, we start with Equation 4-7 and
assume that the only noncash charge (NCC) is depreciation (Dep):
FCFF  NI  Dep  Int(1  Tax rate) FCInv  WCInv
Net income (NI) can be expressed as
NI  (EBIT – Int)(1 – Tax rate) EBIT(1 – Tax rate) – Int(1 – Tax rate)
Substituting this equation for NI in Equation 4-7, we have
FCFF  EBIT(1 – Tax rate)  Dep – FCInv – WCInv (4-12)
To get FCFF from EBIT, we multiply EBIT by (1 – Tax rate), add back depreciation, and
then subtract the investments in fixed capital and working capital.
The relationship between FCFF and EBITDA can also be easily shown. Net income can
be expressed as
NI  (EBITDA  Dep  Int)(1  Tax rate)  EBITDA(1  Tax rate)
 Dep(1  Tax rate) – Int(1  Tax rate)
Substituting this equation for NI in Equation 4-7 results in
FCFF  EBITDA(1  Tax rate)  Dep(Tax rate)  FCInv  WCInv (4-13)
FCFF equals EBITDA times (1 – Tax rate) plus depreciation times the tax rate minus invest-
ments in fixed capital and working capital. In comparing Equations 4-12 and 4-13, note the
difference in how depreciation is handled.
Many adjustments for noncash charges that are required to calculate FCFF when starting
from net income are not required when starting from EBIT or EBITDA. In the calculation
of net income, many noncash charges are made after computing EBIT or EBITDA, so
they do not need to be added back when calculating FCFF based on EBIT or EBITDA.
Another important consideration is that some noncash charges, such as depreciation, are tax
deductible. A noncash charge that affects taxes must be accounted for.
In summary, in calculating FCFF from EBIT or EBITDA, whether an adjustment for
a noncash charge is needed depends on where in the income statement the charge has been
deducted; furthermore, the form of any needed adjustment depends on whether the noncash
charge is a tax-deductible expense.
We can also calculate FCFE (instead of FCFF) from EBIT or EBITDA. An easy way to
obtain FCFE based on EBIT or EBITDA is to use Equation 4-12 (the expression for FCFF
in terms of EBIT) or Equation 4-13 (the expression for FCFF in terms of EBITDA), respec-
tively, and then subtract Int(1 – Tax rate) and add net borrowing, because FCFE is related to
FCFF as follows (see Equation 4-9):

FCFE  FCFF – Int(1 – Tax rate)  Net borrowing

Example 4-7 uses the Pitts Corporation financial statements to find FCFF and FCFE
from EBIT and EBITDA.

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 170 Equity Asset Valuation

EXAMPLE 4-7 Adjusting EBIT and EBITDA to Find FCFF

and FCFE

The Pitts Corporation (financial statements provided in Example 4-6) had EBIT of
$500 million and EBITDA of $800 million in 2007. Show the adjustments that would
be required to find FCFF and FCFE:

1. Starting from EBIT.

2. Starting from EBITDA.

Solution to 1: To get FCFF from EBIT using Equation 4-12, we carry out the follow-
ing (in millions):

EBIT(1 – Tax rate)  500(1 – 0.40) $300

Plus: Net noncash charges 300
Less: Net investment in fixed capital 400
Less: Net increase in working capital 45
Free cash flow to the firm $155

or
FCFF  EBIT(1  Tax rate)  Dep  FCInv  WCInv
 500(10.40)300  400  45  $155 million
To obtain FCFE, make the appropriate adjustments to FCFF:
FCFE FCFF  Int(1  Tax rate)  Net borrowing
155  100(1  0.40)  75  $170 million
Solution to 2: To obtain FCFF from EBITDA using Equation 4-13, we do the follow-
ing (in millions):

EBITDA(1 – Tax rate)  $800(1 – 0.40) $480

Plus: Dep(Tax rate)  $300(0.40) 120
Less: Net investment in fixed capital 400
Less: Net increase in working capital 45
Free cash flow to the firm $155

or
FCFF  EBITDA(1Tax rate)  Dep(Tax rate)  FCInv  WCInv
 800(10.40)  300(0.40)  400  45  $155 million
Again, to obtain FCFE, make the appropriate adjustments to FCFF:
FCFE  FCFF  Int(1Tax rate)  Net borrowing
 155  100(1  0.40)75  $170 million

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 Chapter 4 Free Cash Flow Valuation 171

3.6. FCFF and FCFE on a Uses-of-Free-Cash-Flow Basis

Prior sections illustrated the calculation of FCFF and FCFE from various income or cash flow
starting points (e.g., net income or cash flow from operations). Those approaches to calculating
free cash flow can be characterized as showing the sources of free cash flow. An alternative perspec-
tive examines the uses of free cash flow. In the context of calculating FCFF and FCFE, analyzing
free cash flow on a uses basis serves as a consistency check on the sources calculation and may
reveal information relevant to understanding a company’s capital structure policy or cash position.
In general, a firm has the following alternative uses of positive FCFF: (1) Retain the
cash and thus increase the firm’s balances of cash and marketable securities; (2) use the cash
for payments to providers of debt capital (i.e., interest payments and principal payments in
excess of new borrowings); and (3) use the cash for payments to providers of equity capital
(i.e., dividend payments and/or share repurchases in excess of new share issuances). Similarly,
a firm has the following general alternatives for covering negative free cash flows: draw down
cash balances, borrow additional cash, or issue equity.
The effects on the company’s capital structure of its transactions with capital providers
should be noted. For a simple example, assume that free cash flows are zero and that the com-
pany makes no change to its cash balances. Obtaining cash via net new borrowings and using
the cash for dividends or net share repurchases will increase the company’s leverage, whereas
obtaining cash from net new share issuances and using that cash to make principal payments
in excess of new borrowings will reduce leverage.
We calculate uses of FCFF as follows:
Uses of FCFF 
Increases (or minus decreases) in cash balances
Plus: Net payments to providers of debt capital, calculated as:

• Plus: Interest expense  (1 – Tax rate)

• Plus: Repayment of principal in excess of new borrowing (or minus new borrowing
in excess of debt repayment if new borrowing is greater)

Plus: Payments to providers of equity capital, calculated as:

• Plus: Cash dividends

• Plus: Share repurchases in excess of share issuance (or minus new share issuance in
excess of share repurchases if share issuance is greater)

Uses of FCFF must equal sources of FCFF as previously calculated.

Free cash flows to equity reflect free cash flows to the firm net of the cash used for pay-
ments to providers of debt capital. Accordingly, we can calculate FCFE as follows:
Uses of FCFE 
Plus: Increases (or minus decreases) in cash balances
Plus: Payments to providers of equity capital, calculated as:

• Plus: Cash dividends

• Plus: Share repurchases in excess of share issuance (or minus new share issuance in
excess of share repurchases if share issuance is greater)

Again, the uses of FCFE must equal the sources of FCFE (calculated previously).

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 172 Equity Asset Valuation

To illustrate the equivalence of sources and uses of FCFF and FCFE for the Pitts
Corporation, whose financial statements are given in Exhibit 4-11 in Example 4-6, note the
following for 2007:

• The increase in the balance of cash and equivalents was $10, calculated as $200 – $190.
• After-tax interest expense was $60, calculated as Interest expense  (1 – Tax rate)  $100 
(1 – 0.40).
• Net borrowing was $75, calculated as increase in borrowing minus repayment of debt: $50
(increase in notes payable)  $25 (increase in long-term debt).
• Cash dividends totaled $160.
• Share repurchases and issuance both equaled $0.

FCFF, previously calculated, was $155. Pitts Corporation used the FCFF as follows:

Increase in balance of cash and cash equivalents $10

Plus: After-tax interest payments to providers of debt capital $60
7
Minus: New borrowing ($75)
Plus: Payments of dividends to providers of equity capital $160
Plus: Share repurchases in excess of share issuances (or minus new share issuance in
excess of share repurchases) $0
Total uses of FCFF $155

FCFE, previously calculated, was $170. Pitts Corporation used the FCFE as follows:

Increase in balance of cash and cash equivalents $10

Plus: Payments of dividends to providers of equity capital $160
Plus: Share repurchases in excess of share issuances (or minus new share issuance in
excess of share repurchases) $0
Total uses of FCFE $170

In summary, an analysis of the uses of free cash flows shows that Pitts Corporation was
using free cash flows to manage its capital structure by increasing debt. The additional debt
was not needed to cover capital expenditures; the statement of cash flows showed that the
company’s operating cash flows of $495 were more than adequate to cover its capital expen-
ditures of $400. Instead, the additional debt was used, in part, to make dividend payments to
the company’s shareholders.

3.7. Forecasting FCFF and FCFE

Computing FCFF and FCFE from historical accounting data is relatively straightforward. In
some cases, these data are used directly to extrapolate free cash flow growth in a single-stage
free cash flow valuation model. On other occasions, however, the analyst may expect that the
7
Payments of principal to providers of debt capital in excess of new borrowings are a use of free cash
flow. Here, the corporation did not use its free cash flow to repay debt; rather, it borrowed new debt,
which increased the cash flows available to be used for providers of equity capital.

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 Chapter 4 Free Cash Flow Valuation 173

future free cash flows will not bear a simple relationship to the past. The analyst who wishes
to forecast future FCFF or FCFE directly for such a company must forecast the individual
components of free cash flow. This section extends our previous presentation on computing
FCFF and FCFE to the more complex task of forecasting FCFF and FCFE.
One method for forecasting free cash flow involves applying some constant growth rate
to a current level of free cash flow (possibly adjusted). The simplest basis for specifying the
future growth rate is to assume that a historical growth rate will also apply to the future. This
approach is appropriate if a company’s free cash flow has tended to grow at a constant rate
and if historical relationships between free cash flow and fundamental factors are expected
to continue. Example 4-8 asks that the reader apply this approach to the Pitts Corporation
based on 2007 FCFF of $155 million as calculated in Examples 4-6 and 4-7.

EXAMPLE 4-8 Constant Growth in FCFF

Use Pitts Corporation data to compute its FCFF for the next three years. Assume that
growth in FCFF remains at the historical levels of 15 percent per year. The answer is
(in millions):

2007 Actual 2008 Estimate 2009 Estimate 2010 Estimate

FCFF 155.00 178.25 204.99 235.74

A more complex approach is to forecast the components of free cash flow. This approach
is able to capture the complex relationships among the components. One popular method8
is to forecast the individual components of free cash flow: EBIT(1 – Tax rate), net noncash
charges, investment in fixed capital, and investment in working capital. EBIT can be fore-
casted directly or by forecasting sales and the company’s EBIT margin based on an analysis of
historical data and the current and expected economic environment. Similarly, analysts can
base forecasts of capital needs on historical relationships between increases in sales and invest-
ments in fixed and working capital.
In this discussion, we illustrate a simple sales-based forecasting method for FCFF and
FCFE based on the following major assumption:
Investment in fixed capital in excess of depreciation (FCInv – Dep) and investment in
working capital (WCInv) both bear a constant relationship to forecast increases in the
size of the company as measured by increases in sales.
In addition, for FCFE forecasting, we assume that the capital structure represented by the
debt ratio (DR)—debt as a percentage of debt plus equity—is constant. Under that assump-
tion, DR indicates the percentage of the investment in fixed capital in excess of depreciation
(also called net new investment in fixed capital) and in working capital that will be financed by
debt. This method involves a simplification because it considers depreciation as the only noncash
charge, so the method does not work well when that approximation is not a good assumption.
If depreciation reflects the annual cost for maintaining the existing capital stock, the dif-
ference between fixed capital investment and depreciation—incremental FCInv—should be

8
See Rappaport (1997) for a variation of this model.

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 174 Equity Asset Valuation

related to the capital expenditures required for growth. In this case, the following inputs are
needed:

• Forecasts of sales growth rates.

• Forecasts of the after-tax operating margin (for FCFF forecasting) or profit margin (for
FCFE forecasting).
• An estimate of the relationship of incremental FCInv to sales increases.
• An estimate of the relationship of WCInv to sales increases.
• An estimate of DR.

In the case of FCFF forecasting, FCFF is calculated by forecasting EBIT(1 – Tax rate)
and subtracting incremental fixed capital expenditures and incremental working capital
expenditures (see Rappaport 1997). To estimate FCInv and WCInv, we multiply their past
proportion to sales increases by the forecasted sales increases. Incremental fixed capital expen-
ditures as a proportion of sales increases are computed as follows:
Capital expenditures  Depreciation expense
Increase in sales
Similarly, incremental working capital expenditures as a proportion of sales increases are
Increase in working capital
Increase in sales
When depreciation is the only significant net noncash charge, this method yields the
same results as the previous equations for estimating FCFF or FCFE. Rather than adding
back all depreciation and subtracting all capital expenditures when starting with EBIT(1– Tax
rate), this approach simply subtracts the net capital expenditures in excess of depreciation.
Although the recognition may not be obvious, this approach recognizes that capi-
tal expenditures have two components: those expenditures necessary to maintain existing
capacity (fixed capital replacement) and those incremental expenditures necessary for growth.
In forecasting, the expenditures to maintain capacity are likely to be related to the current
level of sales, and the expenditures for growth are likely to be related to the forecast of sales
growth.
When forecasting FCFE, analysts often make an assumption that the financing of the
company involves a target debt ratio. In this case, they assume that a specified percentage
of the sum of (1) net new investment in fixed capital (new fixed capital minus depreciation
expense) and (2) increase in working capital is financed based on a target DR. This assump-
tion leads to a simplification of FCFE calculations. If we assume that depreciation is the only
noncash charge, Equation 4-10, which is FCFE  NI  NCC – FCInv – WCInv  Net
borrowing, becomes
FCFE  NI – (FCInv – Dep) – WCInv  Net borrowing (4-14)
Note that FCInv – Dep represents the incremental fixed capital expenditure net of deprecia-
tion. By assuming a target DR, we eliminated the need to forecast net borrowing and can use
the expression
Net borrowing  DR(FCInv – Dep)  DR(WCInv)
By using this expression, we do not need to forecast debt issuance and repayment on an
annual basis to estimate net borrowing. Equation 4-14 then becomes

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 Chapter 4 Free Cash Flow Valuation 175

FCFE  NI  (FCInv  Dep)  WCInv  (DR)(FCInv  Dep) (DR)(WCInv)

or
FCFE  NI – (1 – DR)(FCInv – Dep) – (1 –DR)(WCInv) (4-15)
Equation 4-15 says that FCFE equals NI minus the amount of fixed capital expenditure
(net of depreciation) and working capital investment that is financed by equity. Again for
Equation 4-15, we have assumed that the only noncash charge is depreciation.
Examples 4-9 and 4-10 illustrate this sales-based method for forecasting free cash flow to
the firm.

EXAMPLE 4-9 Free Cash Flow Tied to Sales

Carla Espinosa is an analyst following Pitts Corporation at the end of 2007. From the
data in Example 4-6, she can see that the company’s sales for 2007 were $3,000 mil-
lion, and she assumes that sales grew by $300 million from 2006 to 2007. Espinosa
expects Pitts Corporation’s sales to increase by 10 percent per year thereafter. Pitts
Corporation is a fairly stable company, so Espinosa expects it to maintain its historical
EBIT margin and proportions of incremental investments in fixed and working capital.
Pitts Corporation’s EBIT for 2007 is $500 million; its EBIT margin is 16.67 percent
(500/3,000), and its tax rate is 40 percent.
Note from Pitts Corporation’s 2007 cash flow statement (Exhibit 4-11) the
amount for “purchases of fixed assets” (i.e., capital expenditures) of $400 million and
depreciation of $300 million. Thus, incremental fixed capital investment in 2007 was
Capital expenditures  Depreciation expense 400  300
  33.33%
Increase in sales 300
Incremental working capital investment in the past year was
Increase in working capital 45
  15%
Increase in sales 300
So, for every $100 increase in sales, Pitts Corporation invests $33.33 in new equip-
ment in addition to replacement of depreciated equipment and $15 in working capital.
Espinosa forecasts FCFF for 2008 as follows (dollars in millions):

Sales $3,300 Up 10 percent

EBIT 550 16.67 percent of sales
EBIT(1 – Tax rate) 330 Adjusted for 40 percent tax rate
Incremental FC (100) 33.33 percent of sales increase
Incremental WC (45) 15 percent of sales increase
FCFF $185

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 176 Equity Asset Valuation

This model can be used to forecast multiple periods and is flexible enough to allow vary-
ing sales growth rates, EBIT margins, tax rates, and rates of incremental capital increases.

EXAMPLE 4-10 Free Cash Flow Growth Tied to Sales Growth

Continuing her work, Espinosa decides to forecast FCFF for the next five years. She
is concerned that Pitts Corporation will not be able to maintain its historical EBIT
margin and that the EBIT margin will decline from the current 16.67 percent to 14.5
percent in the next five years. Exhibit 4-12 summarizes her forecasts.

EXHIBIT 4-12 Free Cash Flow Growth for Pitts Corporation (dollars in millions)
Year 1 Year 2 Year 3 Year 4 Year 5
Sales growth 10.00% 10.00% 10.00% 10.00% 10.00%
EBIT margin 16.67% 16.00% 15.50% 15.00% 14.50%
Tax rate 40.00% 40.00% 40.00% 40.00% 40.00%
Incremental FC investment 33.33% 33.33% 33.33% 33.33% 33.33%
Incremental WC investment 15.00% 15.00% 15.00% 15.00% 15.00%
Prior-year sales $3,000.00
Sales forecast $3,300.00 $3,630.00 $3,993.00 $4,392.30 $4,831.53
EBIT forecast 550.00 580.80 618.92 658.85 700.57
EBIT(1 – Tax rate) 330.00 348.48 371.35 395.31 420.34
Incremental FC (100.00) (110.00) (121.00) (133.10) (146.41)
Incremental WC (45.00) (49.50) (54.45) (59.90) (65.88)
FCFF $185.00 $188.98 $195.90 $202.31 $208.05

The model need not begin with sales; it could start with net income, cash flow from
operations, or EBITDA.
A similar model can be designed for FCFE, as shown in Example 4-11. In the case of
FCFE, the analyst should begin with net income and must also forecast any net new borrow-
ing or net preferred stock issue.

EXAMPLE 4-11 Finding FCFE from Sales Forecasts

Espinosa decides to forecast FCFE for the year 2008. She uses the same expectations
derived in Example 4-9. Additionally, she expects the following:

• The profit margin will remain at 8 percent ( 240/3,000).

• The company will finance incremental fixed and working capital investments with 50
percent debt—the target DR. Espinosa’s forecast for 2008 is as follows (dollars in millions):

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 Chapter 4 Free Cash Flow Valuation 177

Sales $3,300 Up 10 percent

NI 264 8.0 percent of sales
Incremental FC (100) 33.33 percent of sales increase
Incremental WC (45) 15 percent of sales increase
Net borrowing 72.50 (100 FCInv  45 WCInv)  50%
FCFE $191.50

When the company being analyzed has significant noncash charges other than deprecia-
tion expense, the approach we have just illustrated will result in a less accurate estimate of
FCFE than one obtained by forecasting all the individual components of FCFE. In some
cases, the analyst will have specific forecasts of planned components, such as capital expen-
ditures. In other cases, the analyst will study historical relationships, such as previous capital
expenditures and sales levels, to develop a forecast.

3.8. Other Issues in Free Cash Flow Analysis

We have already presented a number of practical issues that arise in using free cash flow valu-
ation models. Other issues relate to analyst adjustments to CFO, the relationship between
free cash flow and dividends, and valuation with complicated financial structures.

3.8.1. Analyst Adjustments to CFO

Although many corporate financial statements are straightforward, some are not transparent
(i.e., the quality of the reported numbers and of disclosures is not high). Sometimes, difficul-
ties in analysis arise because the companies and their transactions are more complicated than
the preceding Pitts Corporation example.
For instance, in many corporate financial statements, the changes in balance sheet items
(the increase in an asset or the decrease in a liability) differ from the changes reported in the
statement of cash flows. Similarly, depreciation in the statement of cash flows may differ from
depreciation expense in the income statement. How do such problems arise?
Factors that can cause discrepancies between changes in balance sheet accounts and the
changes reported in the statement of cash flows include acquisitions or divestitures and the presence
of nondomestic subsidiaries. For example, an increase in an inventory account may result from pur-
chases from suppliers (which is an operating activity) or from an acquisition or merger with another
company that has inventory on its balance sheet (which is an investing activity). Discrepancies may
also occur from currency translations of the earnings of nondomestic subsidiaries.
Because the CFO figure from the statement of cash flows may be contaminated by cash
flows arising from financing and/or investing activities, when analysts use CFO in a valua-
tion context, ideally they should remove such contaminations. The resulting analyst-adjusted
CFO is then the starting point for free cash flow calculations.

3.8.2. Free Cash Flow versus Dividends and Other Earnings Components
Many analysts have a strong preference for free cash flow valuation models over dividend dis-
count models. Although one type of model may have no theoretical advantage over another
type, legitimate reasons to prefer one model can arise in the process of applying free cash
flow models versus DDMs. First, many corporations pay no, or very low, cash dividends.
Using a DDM to value these companies is difficult because they require forecasts about when

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 178 Equity Asset Valuation

dividends will be initiated, the level of dividends at initiation, and the growth rate or rates
from that point forward. Second, dividend payments are at the discretion of the corporation’s
board of directors. Therefore, they may imperfectly signal the company’s long-run profitability.
Some corporations clearly pay dividends that are substantially less than their free cash
flow, and others pay dividends that are substantially more. Finally, as mentioned earlier, divi-
dends are the cash flow actually going to shareholders whereas free cash flow to equity is the
cash flow available to be distributed shareholders without impairing the company’s value. If a
company is being analyzed because it is a target for takeover, free cash flow is the appropriate
cash flow measure; once the company is taken over, the new owners will have discretion over
how free cash flow is used (including its distribution in the form of dividends).
We have defined FCFF and FCFE and presented alternative (equivalent) ways to cal-
culate both of them. So the reader should have a good idea of what is included in FCFF or
FCFE but may wonder why some cash flows are not included. Specifically, what impact do
dividends, share repurchases, share issuance, or changes in leverage have on FCFF and FCFE?
The simple answer is: not much. Recall the formulas for FCFF and FCFE:
FCFF  NI  NCC  Int(1  Tax rate)  FCInv  WCInv
and
FCFE  NI  NCC  FCInv  WCInv  Net borrowing
Notice that dividends and share repurchases and issuance are absent from the formulas.
The reason is that FCFF and FCFE are the cash flows available to investors or to stockholders;
dividends and share repurchases are uses of these cash flows. So the simple answer is that trans-
actions between the company and its shareholders (through cash dividends, share repurchases,
and share issuances) do not affect free cash flow. Leverage changes, such as the use of more debt
financing, have some impact because they increase the interest tax shield (reduce corporate taxes
because of the tax deductibility of interest) and reduce the cash flow available to equity. In the
long run, the investing and financing decisions made today will affect future cash flows.
If all the inputs were known and mutually consistent, a DDM and an FCFE model
would result in identical valuations for a stock. One possibility would be that FCFE equals
cash dividends each year. Then both cash flow streams would be discounted at the required
return for equity and would have the same present value.
Generally, however, FCFE and dividends will differ, but the same economic forces that
lead to low (high) dividends lead to low (high) FCFE. For example, a rapidly growing com-
pany with superior investment opportunities will retain a high proportion of earnings and
pay low dividends. This same company will have high investments in fixed capital and work-
ing capital and have a low FCFE (which is clear from the expression FCFE  NI  NCC 
FCInv  WCInv  Net borrowing). Conversely, a mature company that is investing rela-
tively little might have high dividends and high FCFE. In spite of this tendency, however,
FCFE and dividends will usually differ.
FCFF and FCFE, as defined in this book, are measures of cash flow designed for
valuation of the firm or its equity. Other definitions of free cash flow frequently appear in text-
books, articles, and vendor-supplied databases of financial information on public companies.
In many cases, these other definitions of free cash flow are not designed for valuation pur-
poses and thus should not be used for valuation. Using numbers supplied by others without
knowing exactly how they are defined increases the likelihood of making errors in valuation.
As consumers and producers of research, analysts should understand (if consumers) or make
clear (if producers) the definition of free cash flow being used.

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 Chapter 4 Free Cash Flow Valuation 179

Because using free cash flow analysis requires considerable care and understanding, some
practitioners erroneously use earnings components such as NI, EBIT, EBITDA, or CFO in
a discounted cash flow valuation. Such mistakes may lead the practitioner to systematically
overstate or understate the value of a stock. Shortcuts can be costly.
A common shortcut is to use EBITDA as a proxy for the cash flow to the firm. Equation
4-13 clearly shows the differences between EBITDA and FCFF:
FCFF  EBITDA(1  Tax rate)  Dep(Tax rate)  FCInv  WCInv
Depreciation charges as a percentage of EBITDA differ substantially for different companies
and industries, as does the depreciation tax shield (the depreciation charge times the tax rate).
Although FCFF captures this difference, EBITDA does not. EBITDA also does not account for
the investments a company makes in fixed capital or working capital. Hence, EBITDA is a poor
measure of the cash flow available to the company’s investors. Using EBITDA (instead of free
cash flow) in a DCF model has another important aspect as well: EBITDA is a before-tax mea-
sure, so the discount rate applied to EBITDA would be a before-tax rate. The WACC used to
discount FCFF is an after-tax cost of capital.
EBITDA is a poor proxy for free cash flow to the firm because it does not account for
the depreciation tax shield and the investment in fixed capital and working capital, but it is
an even poorer proxy for free cash flow to equity. From a stockholder’s perspective, additional
defects of EBITDA include its failure to account for the after-tax interest costs or cash flows
from new borrowing or debt repayments. Example 4-12 shows the mistakes sometimes made
in discussions of cash flows.

EXAMPLE 4-12 The Mistakes of Using Net Income for FCFE

and EBITDA for FCFF

A recent job applicant made some interesting comments about FCFE and FCFF: “I don’t
like the definitions for FCFE and FCFF because they are unnecessarily complicated and
confusing. The best measure of FCFE, the funds available to pay dividends, is simply
net income. You take the net income number straight from the income statement and
don’t need to make any further adjustments. Similarly, the best measure of FCFF, the
funds available to the company’s suppliers of capital, is EBITDA. You can take EBITDA
straight from the income statement, and you don’t need to consider using anything else.”
How would you respond to the job applicant’s definition of (1) FCFE and (2) FCFF?
Solution to 1: The FCFE is the cash generated by the business’s operations less the
amount it must reinvest in additional assets plus the amounts it is borrowing. Equation
4-10, which starts with net income to find FCFE, shows these items:

Free cash flow to equity  Net income available to common shareholders

Plus: Net noncash charges
Less: Investment in fixed capital
Less: Investment in working capital
Plus: Net borrowing

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 180 Equity Asset Valuation

Net income does not include several cash flows, so net income tells only part
of the overall story. Investments in fixed or working capital reduce the cash available
to stockholders, as do loan repayments. New borrowing increases the cash available.
FCFE, however, includes the cash generated from operating the business and also
accounts for the investing and financing activities of the company. Of course, a special
case exists in which net income and FCFE are the same. This case occurs when new
investments exactly equal depreciation and the company is not investing in working
capital or engaging in any net borrowing.
Solution to 2: Assuming that EBITDA equals FCFF introduces several possible mis-
takes. Equation 4-13 highlights these mistakes:

Free cash flow to the firm  EBITDA(1 – Tax rate)

Plus: Depreciation(Tax rate)
Less: Investment in fixed capital
Less: Investment in working capital

The applicant is ignoring taxes, which obviously reduce the cash available to the
company’s suppliers of capital.

3.8.3. Free Cash Flow and Complicated Capital Structures

For the most part, the discussion of FCFF and FCFE so far has assumed the company has a sim-
ple capital structure with two sources of capital, namely debt and equity. Including preferred stock
as a third source of capital requires the analyst to add terms to the equations for FCFF and FCFE
to account for the dividends paid on preferred stock and for the issuance or repurchase of preferred
shares. Instead of including those terms in all of the equations, we chose to leave preferred stock
out because only a few corporations use preferred stock. For companies that do have preferred
stock, however, the effects of the preferred stock can be incorporated in the valuation models.
For example, in Equation 4-7, which calculates FCFF starting with net income avail-
able to common shareholders, preferred dividends paid would be added to the cash flows to
obtain FCFF. In Equation 4-10, which calculates FCFE starting with net income available
to common shareholders, if preferred dividends were already subtracted when arriving at net
income, no further adjustment for preferred dividends would be required. Issuing (redeem-
ing) preferred stock increases (decreases) the cash flow available to common stockholders,
however, so this term would have to be added in. The existence of preferred stock in the capi-
tal structure has many of the same effects as the existence of debt, except that unlike interest
payments on debt, preferred stock dividends paid are not tax deductible.
Example 4-13 shows how to calculate WACC, FCFE, and FCFF when the company has
preferred stock.

EXAMPLE 4-13 FCFF Valuation with Preferred Stock in the

Capital Structure

Welch Corporation uses bond, preferred stock, and common stock financing. The mar-
ket value of each of these sources of financing and the before-tax required rates of return
for each are given in Exhibit 4-13.

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 Chapter 4 Free Cash Flow Valuation 181

EXHIBIT 4-13 Welch Corporation Capital Structure (dollars in millions)

Market Value Required Return
Bonds $400 8.0%
Preferred stock $100 8.0%
Common stock $500 12.0%
Total $1,000

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 Welch Corporation
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?

Solution to 1: Based on the weights and after-tax costs of each source of capital, the WACC is
400 100 500
WACC  8%(1 0.30) 8%  12%  9.04%
1, 000 1, 000 1, 000
Solution to 2: If the company did not issue preferred stock, FCFF would be
FCFF  NI  NCC  Int(1  Tax rate)  FCInv  WCInv
If preferred stock dividends have been paid (and net income is income available to
common shareholders), the preferred dividends must be added back just as after-
tax interest expenses are. The modified equation (including preferred dividends) for
FCFF is
FCFF  NI  NCC  Int(1  Tax rate)  Preferred dividends FCInv  WCInv
For Welch Corporation, FCFF is
FCFF  110  40  32(1  0.30)  8  70  20  $90.4 million
Solution to 3: The total value of the firm is
FCFF1 90.4(1.04) 94.016
Firm value     $1,865.40 million
WACC  g 0.0904  0.04 0.0504

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 182 Equity Asset Valuation

The value of (common) equity is the total value of the company minus the value of
debt and preferred stock:
Equity  1,865.40  400  100  $1,365.40 million
Solution to 4: With no preferred stock, FCFE is
FCFE  NI  NCC  FCInv  WCInv  Net borrowing
If the company has preferred stock, the FCFE equation is essentially the same. Net
borrowing in this case is the total of new debt borrowing and net issuances of new pre-
ferred stock. For Welch Corporation, FCFE is
FCFE  110  40  70  20  25  $85 million
Solution to 5: Valuing FCFE, which is growing at 5.4 percent, produces a value of equity of
FCFE l 85(1.054) 89.59
Equity     $1,357.42 million
r  g 0.12  0.054 0.066

Paying cash dividends on common stock does not affect FCFF or FCFE, which are the
amounts of cash available to all investors or to common stockholders. It is simply a use of the
available cash. Share repurchases of common stock also do not affect FCFF or FCFE. Share
repurchases are, in many respects, a substitute for cash dividends. Similarly, issuing shares of
common stock does not affect FCFF or FCFE.
Changing leverage, however (changing the amount of debt financing in the company’s capi-
tal structure), does have some effects on FCFE particularly. An increase in leverage will not affect
FCFF (although it might affect the calculations used to arrive at FCFF). An increase in leverage
affects FCFE in two ways. In the year the debt is issued, it increases the FCFE by the amount of
debt issued. After the debt is issued, FCFE is then reduced by the after-tax interest expense.
In Section 3, we have discussed the concepts of FCFF and FCFE and their estimation.
The next section presents additional valuation models that use forecasts of FCFF or FCFE to
value the firm or its equity. These free cash flow models are similar in structure to dividend
discount models, although the analyst must face the reality that estimating free cash flows is
more time-consuming than estimating dividends.

4. FREE CASH FLOW MODEL VARIATIONS

Section 4 presents several extensions of the free cash flow models presented earlier. In many
cases, especially when inflation rates are volatile, analysts will value real cash flows instead of
nominal values. As with dividend discount models, free cash flow models are sensitive to the
data inputs, so analysts routinely perform sensitivity analyses of their valuations.
In Section 2.3, we presented the single-stage free cash flow model, which has a constant
growth rate. In the following, we use the single-stage model to address selected valuation
issues; we then present multistage free cash flow models.

4.1. An International Application of the Single-Stage Model

Valuation by using real (inflation-adjusted) values instead of nominal values has much appeal when
inflation rates are high and volatile. Many analysts use this adaptation for both domestic and nondo-
mestic stocks, but the use of real values is especially helpful for valuing international stocks. Special

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 Chapter 4 Free Cash Flow Valuation 183

challenges to valuing equities from multiple countries include (1) incorporating economic factors—
such as interest rates, inflation rates, and growth rates—that differ among countries and (2) dealing
with varied accounting standards. Furthermore, performing analyses in multiple countries challenges
the analyst—particularly a team of analysts—to use consistent assumptions for all countries.
Several securities firms have adapted the single-stage FCFE model to address some of the
challenges of international valuation. They choose to analyze companies by using real cash
flows and real discount rates instead of nominal values. To estimate real discount rates, they
use a modification of the build-up method mentioned in Chapter 2. Starting with a country
return, which is a real required rate of return for stocks from a particular country, they then
make adjustments to the country return for the stock’s industry, size, and leverage:

Country return (real) x.xx%

/– Industry adjustment x.xx%
/– Size adjustment x.xx%
/– Leverage adjustment x.xx%
Required rate of return (real) x.xx%

The adjustments in the model should have sound economic justification. They should
reflect factors expected to affect the relative risk and return associated with an investment.
The securities firms making these adjustments predict the growth rate of FCFE also in
real terms. The firms supply their analysts with estimates of the real economic growth rate for
each country, and each analyst chooses a real growth rate for the stock being analyzed that is
benchmarked against the real country growth rate. This approach is particularly useful for
countries with high or variable inflation rates.
The value of the stock is found with an equation essentially like Equation 4-6 except
that all variables in the equation are stated in real terms:
FCFE 0 (1 g real )
V0 
rreal  g real
Whenever real discount rates and real growth rates can be estimated more reliably than
nominal discount rates and nominal growth rates, this method is worth using. Example 4-14
shows how this procedure can be applied.

EXAMPLE 4-14 Using Real Cash Flows and Discount Rates

for International Stocks

YPF Sociedad Anonima (NYSE: YPF) is an integrated oil and gas company head-
quartered in Buenos Aires, Argentina. Although the company’s cash flows have been
volatile, an analyst has estimated a per-share normalized FCFE of 1.05 Argentine
pesos (ARS) for the year just ended. The real country return for Argentina is 7.30
percent; adjustments to the country return for YPF S.A. are an industry adjustment
of 0.80 percent, a size adjustment of –0.33 percent, and a leverage adjustment of
–0.12 percent. The long-term real growth rate for Argentina is estimated to be 3.0
percent, and the real growth rate of YPF S.A. is expected to be about 0.5 percent
below the country rate. The real required rate of return for YPF S.A. is

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 184 Equity Asset Valuation

Country return (real) 7.30%

Industry adjustment 0.80%
Size adjustment –0.33%
Leverage adjustment –0.12%
Required rate of return 7.65%

The real growth rate of FCFE is expected to be 2.5 percent (3.0 percent – 0.5 percent),
so the value of one share is
FCFE 0 (1 g real ) 1.05(1.025) 1.07625
V0     ARS20.90
rreal  g real 0.0765  0.025 0.0515

4.2. Sensitivity Analysis of FCFF and FCFE Valuations

In large measure, growth in FCFF and in FCFE depends on a company’s future profitabi-
lity. Sales growth and changes in net profit margins dictate future net profits. Sales growth
and profit margins depend on the growth phase of the company and the profitability of the
industry. A highly profitable company in a growing industry can enjoy years of profit growth.
Eventually, however, its profit margins are likely to be eroded by increased competition; sales
growth is also likely to abate because of fewer opportunities for expansion of market size and
market share. Growth rates and the duration of growth are difficult to forecast.
The base-year values for the FCFF or FCFE growth models are also critical. Given the
same required rates of return and growth rates, the value of the firm or the value of equity
will increase or decrease proportionately with the initial value of FCFF or FCFE used.
To examine how sensitive the final valuation is to changes in each of a valuation model’s
input variables, analysts can perform a sensitivity analysis. Some input variables have a much
larger impact on stock valuation than others. Example 4-15 shows the sensitivity of the valu-
ation of Petroleo Brasileiro to four input variables.

EXAMPLE 4-15 Sensitivity Analysis of an FCFE Valuation

Steve Bono is valuing the equity of Petroleo Brasileiro (NYSE: PBR), commonly
known as Petrobras, in early 2007 by using the single-stage (constant-growth) FCFE
model. Estimated FCFE for 2006 is 6.15 Brazilian reals (BRL). Bono’s best estimates
of input values for the analysis are as follows:

• The FCFE growth rate is 7.3 percent.

• The risk-free rate is 10.0 percent.
• The equity risk premium is 5.5 percent.
• Beta is 1.0.

Using the capital asset pricing model (CAPM), Bono estimates that the required rate
of return for Petrobras is

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 Chapter 4 Free Cash Flow Valuation 185

r  E(Ri)  RF  i[E(RM) RF ]  10%  1.0(5.5%) 15.5%

The estimated value per share is
FCFE 0 (1 g ) 6.15(1.073)
V0    BRL 80.48
rg 0.155  0.073

Exhibit 4-14 shows Bono’s base case and the highest and lowest reasonable alterna-
tive estimates. The column “Valuation with Low Estimate” gives the estimated value of
Petrobras based on the low estimate for the variable on the same row of the first column
and the base-case estimates for the remaining three variables. “Valuation with High
Estimate” performs a similar exercise based on the high estimate for the variable at issue.

EXHIBIT 4-14 Sensitivity Analysis for Petrobras Valuation

Base-Case Low High Valuation with Valuation with
Variable Estimate Estimate Estimate Low Estimate High Estimate
Beta 1 0.75 1.25 BRL96.69 BRL68.92
Risk-free rate 10.00% 8.00% 12.00% BRL106.43 BRL64.70
Equity risk premium 5.50% 4.50% 6.50% BRL91.65 BRL71.73
FCFE growth rate 7.3% 5.00% 9.00% BRL61.50 BRL103.13

As Exhibit 4-14 shows, the value of Petrobras is very sensitive to the inputs. Of the
four variables presented, the stock valuation is least sensitive to the range of estimates
for the equity risk premium and beta. The range of estimates for these variables pro-
duces the smallest ranges of stock values (from BRL71.73 to BRL91.65 for the equity
risk premium and from BRL68.92 to BRL96.69 for beta). The stock value is most
sensitive to the extreme values for the risk-free rate and for the FCFE growth rate. Of
course, the variables to which a stock price is most sensitive vary from case to case. A
sensitivity analysis gives the analyst a guide as to which variables are most critical to the
final valuation.

4.3. Two-Stage Free Cash Flow Models

Several two-stage and multistage models exist for valuing free cash flow streams, just as several
such models are available for valuing dividend streams. The free cash flow models are much
more complex than the dividend discount models because to find FCFF or FCFE, the analyst
usually incorporates sales, profitability, investments, financing costs, and new financing.
In two-stage free cash flow models, the growth rate in the second stage is a long-run sus-
tainable growth rate. For a declining industry, the second-stage growth rate could be slightly
below the GDP growth rate. For an industry that is expected to grow in the future faster than
the overall economy, the second-stage growth rate could be slightly greater than the GDP
growth rate.
The two most popular versions of the two-stage FCFF and FCFE models are dis-
tinguished by the pattern of the growth rates in stage 1. In one version, the growth
rate is constant in stage 1 before dropping to the long-run sustainable rate in stage 2.

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 186 Equity Asset Valuation

In the other version, the growth rate declines in stage 1 to reach the sustainable rate at
the beginning of stage 2. This second type of model is like the H-model for discounted
dividend valuation, in which dividend growth rates decline in stage 1 and are constant in
stage 2.
Unlike multistage DDMs, in which the growth rates are consistently dividend growth
rates, in free cash flow models, the growth rate may refer to different variables (which vari-
ables should be stated or should be clear from the context). The growth rate could be the
growth rate for FCFF or FCFE, the growth rate for income (either net income or operating
income), or the growth rate for sales. If the growth rate is for net income, the changes in
FCFF or FCFE also depend on investments in operating assets and the financing of these
investments. When the growth rate in income declines, such as between stage 1 and stage 2,
investments in operating assets probably decline at the same time. If the growth rate is for
sales, changes in net profit margins as well as investments in operating assets and financing
policies will determine FCFF and FCFE.
A general expression for the two-stage FCFF valuation model is
n
FCFFt FCFFn1 1
Firm value  ∑  (4-16)
t 1 (1  WACC)t
(WACC  g ) (1  WACC)n

The summation gives the present value of the first n years of FCFF. The terminal value of the
FCFF from year n  1 forward is FCFFn1/(WACC  g), which is discounted at the WACC
for n periods to obtain its present value. Subtracting the value of outstanding debt gives the
value of equity. The value per share is then found by dividing the total value of equity by the
number of outstanding shares.
The general expression for the two-stage FCFE valuation model is
n
FCFEt FCFE n1 1
Equity value  ∑  (4-17)
t 1 (1 r )t r  g (1 r )n

In this case, the summation is the present value of the first n years of FCFE, and the terminal
value of FCFEn1/(r  g) is discounted at the required rate of return on equity for n years.
The value per share is found by dividing the total value of equity by the number of outstand-
ing shares.
In Equation 4-17, the terminal value of the stock at t  n, TVn, is found by using the
constant-growth FCFE model. In this case, TVn  FCFEn1/(r – g). (Of course, the analyst
might choose to estimate terminal value another way, such as using a price-to-earnings ratio
(P/E) multiplied by the company’s forecasted EPS.) The terminal value estimation is critical
for a simple reason: The present value of the terminal value is often a substantial portion of
the total value of the stock. For example, in Equation 4-17, when the analyst is calculating
the total present value of the first n cash flows (FCFE) and the present value of the terminal
value, the present value of the terminal value is often substantial. In the examples that follow,
the terminal value usually represents a substantial part of total estimated value. The same is
true in practice.

4.3.1. Fixed Growth Rates in Stage 1 and Stage 2

The simplest two-stage FCFF or FCFE growth model has a constant growth rate in each
stage. Example 4-16 finds the value of a firm that has a 20 percent sales growth rate in stage
1 and a 6 percent sales growth rate in stage 2.

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 Chapter 4 Free Cash Flow Valuation 187

EXAMPLE 4-16 A Two-Stage FCFE Valuation Model with a

Constant Growth Rate in Each Stage

Uwe Henschel is doing a valuation of TechnoSchaft on the basis of the following

information:

• Year 0 sales per share  €25.

• Sales growth rate  20 percent annually for three years and 6 percent annually
thereafter.
• Net profit margin  10 percent forever.
• Net investment in fixed capital (net of depreciation)  50 percent of the sales increase.
• Annual increase in working capital  20 percent of the sales increase.
• Debt financing  40 percent of the net investments in capital equipment and work-
ing capital.
• TechnoSchaft beta  1.20; the risk-free rate of return  7 percent; the equity risk
premium  4.5 percent.

The required rate of return for equity is

r  E(Ri)  RF  i[E(RM) RF]  7%  1.2(4.5%) 12.4%
Exhibit 4-15 shows the calculations for FCFE.

EXHIBIT 4-15 FCFE Estimates for TechnoSchaft (in euro)

Year
1 2 3 4 5 6
Sales growth rate 20% 20% 20% 6% 6% 6%
Sales per share 30.000 36.000 43.200 45.792 48.540 51.452
Net profit margin 10% 10% 10% 10% 10% 10%
EPS 3.000 3.600 4.320 4.579 4.854 5.145
Net FCInv per share 2.500 3.000 3.600 1.296 1.374 1.456
WCInv per share 1.000 1.200 1.440 0.518 0.550 0.582
Debt financing per share 1.400 1.680 2.016 0.726 0.769 0.815
FCFE per share 0.900 1.080 1.296 3.491 3.700 3.922
Growth rate of FCFE 20% 20% 169% 6% 6%

In Exhibit 4-15, sales are shown to grow at 20 percent annually for the first three years
and then at 6 percent thereafter. Profits, which are 10 percent of sales, grow at the same
rates. The net investments in fixed capital and working capital are, respectively, 50 percent
of the increase in sales and 20 percent of the increase in sales. New debt financing equals 40
percent of the total increase in net fixed capital and working capital. FCFE is EPS minus
the net investment in fixed capital per share minus the investment in working capital per
share plus the debt financing per share.

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 188 Equity Asset Valuation

Notice that FCFE grows by 20 percent annually for the first three years (i.e., between
t  0 and t  3). Then, between years 3 and 4, when the sales growth rate drops from
20 percent to 6 percent, FCFE increases substantially. In fact, FCFE increases by 169
percent from year 3 to year 4. This large increase in FCFE occurs because profits grow
at 6 percent but the investments in capital equipment and working capital (and the
increase in debt financing) drop substantially from the previous year. In years 5 and 6
in Exhibit 4-15, sales, profit, investments, financing, and FCFE are all shown to grow
at 6 percent.
The stock value is the present value of the first three years’ FCFE plus the present
value of the terminal value of the FCFE from years 4 and later. The terminal value is
FCFE 4 3.491
TV3    €54.55
rg 0.124  0.06
The present values are
0.900 1.080 1.296 54.55
V0      0.801 0.855  0.913  38.415  €40.98
1.124 (1.124)2 (1.124)3 (1.124)3

The estimated value of this stock is € 40.98 per share.

As mentioned previously, the terminal value may account for a large portion of the
value of a stock. In the case of TechnoSchaft, the present value of the terminal value is
€ 38.415 out of a total value of € 40.98. The present value (PV) of the terminal
value is almost 94 percent of the total value of TechnoSchaft stock.

4.3.2. Declining Growth Rate in Stage 1 and Constant Growth in Stage 2

Growth rates usually do not drop precipitously as they do between the stages in the two-stage
model just described, but growth rates can decline over time for many reasons. Sometimes a
small company has a high growth rate that is not sustainable as its market share increases. A
highly profitable company may attract competition that makes it harder for the company to
sustain its high profit margins.
In this section, we present two examples of the two-stage model with declining growth
rates in stage 1. In the first example, the growth rate of EPS declines during stage 1. As a com-
pany’s profitability declines and the company is no longer generating high returns, the company
will usually reduce its net new investment in operating assets. The debt financing accompany-
ing the new investments will also decline. Many highly profitable, growing companies have
negative or low free cash flows. Later, when growth in profits slows, investments will tend to
slow and the company will experience positive cash flows. Of course, the negative cash flows
incurred in the high-growth stage help determine the cash flows that occur in future years.
Example 4-17 models FCFE per share as a function of EPS that declines constantly during
stage 1. Because of declining earnings growth rates, the company in the example also reduces
its new investments over time. The value of the company depends on these free cash flows,
which are substantial after the high-growth (and high-profitability) period has largely elapsed.
The FCFE in Example 4-17 was based on forecasts of future EPS. Analysts often model a
company by forecasting future sales and then estimating the profits, investments, and financing

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 Chapter 4 Free Cash Flow Valuation 189

EXAMPLE 4-17 A Two-Stage FCFE Valuation Model with

Declining Net Income Growth in Stage 1

Vishal Noronha needs to prepare a valuation of Sindhuh Enterprises. Noronha has

assembled the following information for his analysis. It is now the first day of 2008.

• EPS for 2007 is $2.40.

• For the next five years, the growth rate in EPS is given in the following table. In
2012 and beyond, the growth rate will be 7 percent.

2008 2009 2010 2011 2012

Growth rate for EPS 30% 18% 12% 9% 7%

• Net investments in fixed capital (net of depreciation) for the next five years are given
in the following table. After 2012, capital expenditures are expected to grow at 7
percent annually.

2008 2009 2010 2011 2012

Net capital expenditure per share $3.00 $2.50 $2.00 $1.50 $1.00

• The investment in working capital each year will equal 50 percent of the net invest-
ment in capital items.
• Thirty percent of the net investment in fixed capital and investment in working cap-
ital will be financed with new debt financing.
• Current market conditions dictate a risk-free rate of 6.0 percent, an equity risk pre-
mium of 4.0 percent, and a beta of 1.10 for Sindhuh Enterprises.

1. What is the per-share value of Sindhuh Enterprises on the first day of 2008?
2. What should be the trailing P/E on the first day of 2008 and the first day of 2012?

Solution to 1: The required return for Sindhuh should be

r  E(Ri)  RF  i[E(RM ) RF ]  6%  1.1 (4%)  10.4%
The FCFEs for the company for years 2008 through 2012 are given in Exhibit 4-16.
EXHIBIT 4-16 FCFE Estimates for Sindhuh Enterprises (per-share data in U.S. dollars)
Year
2008 2009 2010 2011 2012
Growth rate for EPS 30% 18% 12% 9% 7%
EPS 3.120 3.682 4.123 4.494 4.809
Net FCInv per share 3.000 2.500 2.000 1.500 1.000
WCInv per share 1.500 1.250 1.000 0.750 0.500
a
Debt financing per share 1.350 1.125 0.900 0.675 0.450

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 190 Equity Asset Valuation

FCFE per shareb –0.030 1.057 2.023 2.919 3.759

PV of FCFE discounted at 10.4% –0.027 0.867 1.504 1.965
a
30 percent of (Net FCInv  WCInv).
b
EPS – Net FCInv per share – WCInv per share  Debt financing per share.

Earnings are $2.40 in 2007. Earnings increase each year by the growth rate given
in the table. Net capital expenditures (capital expenditures minus depreciation) are the
amounts that Noronha assumed. The increase in working capital each year is 50 percent
of the increase in net capital expenditures. Debt financing is 30 percent of the total
outlays for net capital expenditures and working capital each year. The FCFE each year
is net income minus net capital expenditures minus increase in working capital plus
new debt financing. Finally, for years 2008 through 2011, the present value of FCFE is
found by discounting FCFE by the 10.4 percent required rate of return for equity.
After 2011, FCFE will grow by a constant 7 percent annually, so the constant
growth FCFE valuation model can be used to value this cash flow stream. At the end
of 2011, the value of the future FCFE is
FCFE 2012 3.759
V2011    $110.56 per share
rg 0.104  0.07

To find the present value of V2011 as of the end of 2007, V2007, we discount V2011 at
10.4 percent for four years:
PV  110.56/(1.104)4  $74.425 per share
The total present value of the company is the present value of the first four years’
FCFE plus the present value of the terminal value, or
V2007   0.027  0.867  1.504  1.965  74.42  $78.73 per share
Solution to 2: Using the estimated $78.73 stock value, we find that the trailing P/E at
the beginning of 2008 is
P/E  78.73/2.40  32.8
At the beginning of 2012, the expected stock value is $110.56 and the previous year’s
EPS is $4.494, so the trailing P/E at this time would be
P/E  110.56/4.494  24.6
After its high-growth phase has ended, the P/E for the company declines substantially.

associated with those sales levels. For large companies, analysts may estimate the sales, profitability,
investments, and financing for each division or large subsidiary. Then they aggregate the free cash
flows for all of the divisions or subsidiaries to get the free cash flow for the company as a whole.
Example 4-18 is a two-stage FCFE model with declining sales growth rates in stage 1,
with profits, investments, and financing keyed to sales. In stage 1, the growth rate of sales
and the profit margin on sales both decline as the company matures and faces more competi-
tion and slower growth.

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 Chapter 4 Free Cash Flow Valuation 191

EXAMPLE 4-18 A Two-Stage FCFE Valuation Model with

Declining Sales Growth Rates

Medina Werks, a manufacturing company headquartered in Canada, has a competitive

advantage that will probably deteriorate over time. Analyst Flavio Torino expects this
deterioration to be reflected in declining sales growth rates as well as declining profit
margins. To value the company, Torino has accumulated the following information:

• Current sales are C$600 million. Over the next six years, the annual sales growth
rate and the net profit margin are projected to be as follows:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Sales growth rate 20% 16% 12% 10% 8% 7%
Net profit margin 14% 13% 12% 11% 10.5% 10%

Beginning in year 6, the 7 percent sales growth rate and 10 percent net profit margin
should persist indefinitely.
• Capital expenditures (net of depreciation) in the amount of 60 percent of the sales
increase will be required each year.
• Investments in working capital equal to 25 percent of the sales increase will also be
required each year.
• Debt financing will be used to fund 40 percent of the investment in net capital items
and working capital.
• The beta for Medina Werks is 1.10; the risk-free rate of return is 6.0 percent; the
equity risk premium is 4.5 percent.
• The company has 70 million outstanding shares.

1. What is the estimated total market value of equity?

2. What is the estimated value per share?
Solution to 1: The required return for Sindhuh should be
r  E(Ri)  RF  i[E(RM ) RF ]  6%  1.1 (4.5%)  10.95%
The annual sales and net profit can be readily found as shown in Exhibit 4-17.

EXHIBIT 4-17 FCFE Estimates for Medina Werks (C$ in millions)

Year
1 2 3 4 5 6
Sales growth rate 20% 16% 12% 10% 8% 7%
Net profit margin 14% 13% 12% 11% 10.50% 10%
Sales 720.000 835.200 935.424 1,028.966 1,111.284 1,189.074
Net profit 100.800 108.576 112.251 113.186 116.685 118.907
Net FCInv 72.000 69.120 60.134 56.125 49.390 46.674
WCInv 30.000 28.800 25.056 23.386 20.579 19.447

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 192 Equity Asset Valuation

Debt financing 40.800 39.168 34.076 31.804 27.988 26.449

FCFE 39.600 49.824 61.137 65.480 74.703 79.235
PV of FCFE at 10.95% 35.692 40.475 44.763 43.211 44.433

As can be seen, sales are expected to increase each year by a declining sales growth rate.
Net profit each year is the year’s net profit margin times the year’s sales. Capital investment
(net of depreciation) equals 60 percent of the sales increase from the previous year. The
investment in working capital is 25 percent of the sales increase from the previous year.
The debt financing each year is equal to 40 percent of the total net investment in capital
items and working capital for that year. FCFE is net income minus the net capital invest-
ment minus the working capital investment plus the debt financing. The present value of
each year’s FCFE is found by discounting FCFE at the required rate of return for equity,
10.95 percent.
In year 6 and beyond, Torino predicts sales to increase at 7 percent annually. Net
income will be 10 percent of sales, so net profit will also grow at a 7 percent annual
rate. Because they are pegged to the 7 percent sales increase, the investments in capi-
tal items and working capital and debt financing will also grow at the same 7 percent
rate. The amounts in year 6 for net income, investment in capital items, investment in
working capital, debt financing, and FCFE will grow at 7 percent.
The terminal value of FCFE in year 6 and beyond is
FCFE 6 79.235
TV5    C$2, 005.95 million
rg 0.1095  0.07
The present value of this amount is
2, 005.95
PV5   C$1,193.12 million
(0.1095)5
The estimated total market value of the firm is the present value of FCFE for years 1
through 5 plus the present value of the terminal value:
MV  35.692  40.475  44.763  43.211  44.433  1,193.12  C$1,401.69 million
Solution to 2: Dividing C$1,401.69 million by the 70 million outstanding shares gives
the estimated value per share of C$20.02.

4.4. Three-Stage Growth Models

Three-stage models are a straightforward extension of the two-stage models. One common
version of a three-stage model is to assume a constant growth rate in each of the three stages.
The growth rates could be for sales, profits, and investments in fixed and working capital;
external financing could be a function of the level of sales or changes in sales. A simpler
model would apply the growth rate to FCFF or FCFE.
A second common model is a three-stage model with constant growth rates in stages 1
and 3 and a declining growth rate in stage 2. Again, the growth rates could be applied to sales
or to FCFF or FCFE. Although future FCFF and FCFE are unlikely to follow the assump-
tions of either of these three-stage growth models, analysts often find such models to be use-
ful approximations.

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 Chapter 4 Free Cash Flow Valuation 193

EXAMPLE 4-19 A Three-Stage FCFF Valuation Model

with Declining Growth in Stage 2

Charles Jones is evaluating Reliant Home Furnishings by using a three-stage growth

model. He has accumulated the following information:

• Current FCFF  $745 million

• Outstanding shares  309.39 million
• Equity beta  0.90, risk-free rate  5.04 percent; equity risk premium  5.5 percent
• Cost of debt  7.1 percent
• Marginal tax rate  34 percent
• Capital structure  20 percent debt, 80 percent equity
• Long-term debt  $1.518 billion
• Growth rate of FCFF 
• 8.8 percent annually in stage 1, years 1–4
• 7.4 percent in year 5, 6.0 percent in year 6, 4.6 percent in year 7
• 3.2 percent in year 8 and thereafter
From the information that Jones has accumulated, estimate the following:

1. WACC.
2. Total value of the firm.
3. Total value of equity.
4. Value per share.

Solution to 1: The required return for equity is

r  E(Ri )  RF  i[E(RM) RF]  5.04%  0.9(5.5%) 9.99%
WACC is
WACC  0.20(7.1%)(1  0.34)  0.80(9.99%)  8.93%
Solution to 2: Exhibit 4-18 displays the projected FCFF for the next eight years and the
present value of each FCFF discounted at 8.93 percent.

EXHIBIT 4-18 Forecasted FCFF for Reliant Home Furnishings

Year
1 2 3 4 5 6 7 8
Growth rate 8.80% 8.80% 8.80% 8.80% 7.40% 6.00% 4.60% 3.20%
FCFF 811 882 959 1,044 1,121 1,188 1,243 1,283
PV at 8.93% 744 743 742 741 731 711 683

The terminal value at the end of year 7 is

FCFE8 1, 283
TV7    $22, 391 million
WACC  g 0.0893  0.032

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 194 Equity Asset Valuation

The present value of this amount discounted at 8.93 percent for seven years is
22, 391
PV of TV7   $12, 304 million
(1.0893)7
The total present value of the first seven years of FCFF is $5,097 million. The total
value of the firm is 12,304  5,097  $17,401 million.
Solution to 3: The value of equity is the value of the firm minus the market value of
debt:
17,401  1,518  $15,883 million
Solution to 4: Dividing the equity value by the number of shares yields the value per
share:
$15,883 million/309.39 million  $51.34

Example 4-19 is a three-stage FCFF valuation model with declining growth rates in stage 2.
The model directly forecasts FCFF instead of deriving FCFF from a more complicated model
that estimates cash flow from operations and investments in fixed and working capital.
The next section discusses an important technical issue, the treatment of nonoperating
assets in valuation.

5. NONOPERATING ASSETS AND FIRM VALUE

Free cash flow valuation focuses on the value of assets that generate or are needed to generate
operating cash flows. If a company has significant nonoperating assets, such as excess cash,9
excess marketable securities, or land held for investment, then analysts often calculate the
value of the firm as the value of its operating assets (e.g., as estimated by FCFF valuation)
plus the value of its nonoperating assets:
Value of firm  Value of operating assets  Value of nonoperating assets (4-18)
In general, if any company asset is excluded from the set of assets being considered in pro-
jecting a company’s future cash flows, the analyst should add that omitted asset’s estimated value
to the cash flows–based value estimate. Some companies have substantial noncurrent investments
in stocks and bonds that are not operating subsidiaries but, rather, financial investments. These
investments should be reflected at their current market value. Those securities reported at book
values on the basis of accounting conventions should be revalued to market values.

6. SUMMARY

Discounted cash flow models are widely used by analysts to value companies.

• Free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) are the cash flows
available to, respectively, all of the investors in the company and to common stockholders.

9
In this case, excess is in relation to what is needed for generating operating cash flows. Estimating
what constitutes excess cash may be difficult; for example, an analyst could consider as excess cash any
amount in excess of the amount predicted by multiplying total assets by the industry median level of
the ratio of cash to total assets.

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 Chapter 4 Free Cash Flow Valuation 195

• Analysts like to use free cash flow (either FCFF or FCFE) as the return
• If the company is not paying dividends.
• If the company pays dividends but the dividends paid differ significantly from the com-
pany’s capacity to pay dividends.
• If free cash flows align with profitability within a reasonable forecast period with which
the analyst is comfortable.
• If the investor takes a control perspective.
• The FCFF valuation approach estimates the value of the firm as the present value of future
FCFF discounted at the weighted average cost of capital:
∞
FCFFt
Firm value  ∑ (1  WACC)
t 1
t

The value of equity is the value of the firm minus the value of the firm’s debt:
Equity value  Firm value  Market value of debt
Dividing the total value of equity by the number of outstanding shares gives the value per
share.
The WACC formula is
MV(Debt) MV(Equity)
WACC  rd (1 Tax rate)  r
MV(Debt)  MV(Equity) MV(Debt)  MV(Equity)

• The value of the firm if FCFF is growing at a constant rate is

FCFF1 FCFF0 (1 g )
Firm value  
WACC  g WACC  g
• With the FCFE valuation approach, the value of equity can be found by discounting FCFE
at the required rate of return on equity, r :
∞
FCFEt
Equity value  ∑
t 1 (1 r )t
Dividing the total value of equity by the number of outstanding shares gives the value per share.
• The value of equity if FCFE is growing at a constant rate is
FCFE1 FCFE 0 (1 g )
Equity value  
rg rg

• FCFF and FCFE are frequently calculated by starting with net income:
FCFF  NI  NCC  Int(1Tax rate)  FCInv  WCInv
FCFE  NI  NCC  FCInv  WCInv  Net borrowing
• FCFF and FCFE are related to each other as follows:
FCFE  FCFF  Int(1  Tax rate)  Net borrowing
• FCFF and FCFE can be calculated by starting from cash flow from operations:
FCFF  CFO  Int(1  Tax rate)  FCInv
FCFE  CFO  FCInv  Net borrowing
• FCFF can also be calculated from EBIT or EBITDA:
FCFF  EBIT(1  Tax rate)  Dep  FCInv  WCInv
FCFF  EBITDA(1  Tax rate)  Dep(Tax rate)  FCInv  WCInv

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 196 Equity Asset Valuation

FCFE can then be found by using FCFE  FCFF  Int(1  Tax rate)  Net borrowing.
• Finding CFO, FCFF, and FCFE may require careful interpretation of corporate financial
statements. In some cases, the needed information may not be transparent.
• Earnings components such as net income, EBIT, EBITDA, and CFO should not be used
as cash flow measures to value a firm. These earnings components either double-count or
ignore parts of the cash flow stream.
• FCFF or FCFE valuation expressions can be easily adapted to accommodate complicated
capital structures, such as those that include preferred stock.
• A general expression for the two-stage FCFF valuation model is
n
FCFFt FCFFn1 1
Firm value  ∑ (1  WACC)  (WACC  g ) (1  WACC)
t 1
t n

• A general expression for the two-stage FCFE valuation model is

n
FCFEt FCFE n1 1
Equity value  ∑ (1 r )
t 1
t

r  g (1 r )n

• One common two-stage model assumes a constant growth rate in each stage, and a second
common model assumes declining growth in stage 1 followed by a long-run sustainable
growth rate in stage 2.
• To forecast FCFF and FCFE, analysts build a variety of models of varying complexity. A
common approach is to forecast sales, with profitability, investments, and financing derived
from changes in sales.
• Three-stage models are often considered to be good approximations for cash flow streams
that, in reality, fluctuate from year to year.
• Nonoperating assets, such as excess cash and marketable securities, noncurrent investment secu-
rities, and nonperforming assets, are usually segregated from the company’s operating assets.
They are valued separately and then added to the value of the company’s operating assets to find
total firm value.

PROBLEMS

1. Indicate the effect on this period’s FCFF and FCFE of a change in each of the items
listed here. Assume a $100 increase in each case and a 40 percent tax rate.
A. Net income.
B. Cash operating expenses.
C. Depreciation.
D. Interest expense.
E. EBIT.
F. Accounts receivable.
G. Accounts payable.
H. Property, plant, and equipment.
I. Notes payable.
J. Cash dividends paid.
K. Proceeds from issuing new common shares.
L. Common shares repurchased.

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 Chapter 4 Free Cash Flow Valuation 197

2. LaForge Systems, Inc. has net income of $285 million for the year 2008. Using
information from the company’s financial statements given here, show the adjustments
to net income that would be required to find:
A. FCFF.
B. FCFE.
C. In addition, show the adjustments to FCFF that would result in FCFE.
LaForge Systems, Inc.
Balance Sheet
In millions 31 December 2007 2008
Assets
Current assets
Cash and equivalents $210 $248
Accounts receivable 474 513
Inventory 520 564
Total current assets 1,204 1,325
Gross fixed assets 2,501 2,850
Accumulated depreciation (604) (784)
Net fixed assets 1,897 2,066
Total assets $3,101 $3,391
Liabilities and shareholders’ equity
Current liabilities
Accounts payable $295 $317
Notes payable 300 310
Accrued taxes and expenses 76 99
Total current liabilities 671 726
Long-term debt 1,010 1,050
Common stock 50 50
Additional paid-in capital 300 300
Retained earnings 1,070 1,265
Total shareholders’ equity 1,420 1,615
Total liabilities and shareholders’ equity $3,101 $3,391
Statement of Income
In millions, except per-share data 31 December 2008
Total revenues $2,215
Operating costs and expenses 1,430
EBITDA 785
Depreciation 180

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 198 Equity Asset Valuation

EBIT 605
Interest expense 130
Income before tax 475
Taxes (at 40 percent) 190
Net income 285
Dividends 90
Addition to retained earnings 195
Statement of Cash Flows
In millions 31 December 2008
Operating activities
Net income $285
Adjustments
Depreciation 180
Changes in working capital
Accounts receivable (39)
Inventories (44)
Accounts payable 22
Accrued taxes and expenses 23
Cash provided by operating activities $427
Investing activities
Purchases of fixed assets 349
Cash used for investing activities $349
Financing activities
Notes payable (10)
Long-term financing issuances (40)
Common stock dividends 90
Cash used for financing activities $40
Cash and equivalents increase (decrease) 38
Cash and equivalents at beginning of year 210
Cash and equivalents at end of year $248
Supplemental cash flow disclosures
Interest paid $130
Income taxes paid $190

Note: The Statement of Cash Flows shows the use of a convention by which the positive
numbers of $349 and $40 for cash used for investing activities and cash used for financing
activities, respectively, are understood to be subtractions, because “cash used” is an outflow.

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 Chapter 4 Free Cash Flow Valuation 199

3. For LaForge Systems, whose financial statements are given in problem 2, show the
adjustments from the current levels of CFO (which is $427 million), EBIT ($605
million), and EBITDA ($785 million) to find
A. FCFF.
B. FCFE.
4. The term free cash flow is frequently applied to cash flows that differ from the definition
for FCFF that should be used to value a firm. Two such definitions of free cash flow are
given below. Compare these two definitions for free cash flow with the technically cor-
rect definition of FCFF used in the text.
A. FCF  Net income  Depreciation and amortization  Cash dividends  Capital
expenditures.
B. FCF  Cash flow from operations (from the statement of cash flows)  Capital
expenditures.
5. Proust Company has FCFF of $1.7 billion and FCFE of $1.3 billion. Proust’s WACC is
11 percent, and its required rate of return for equity is 13 percent. FCFF is expected to
grow forever at 7 percent, and FCFE is expected to grow forever at 7.5 percent. Proust
has debt outstanding of $15 billion.
A. What is the total value of Proust’s equity using the FCFF valuation approach?
B. What is the total value of Proust’s equity using the FCFE valuation approach?
6. Quinton Johnston is evaluating TMI Manufacturing Company, Ltd., which is head-
quartered in Taiwan. In 2008, when Johnston is performing his analysis, the company
is unprofitable. Furthermore, TMI pays no dividends on its common shares. Johnston
decides to value TMI Manufacturing by using his forecasts of FCFE. Johnston gathers
the following facts and assumptions:

• The company has 17.0 billion shares outstanding.

• Sales will be $5.5 billion in 2009, increasing at 28 percent annually for the next four
years (through 2013).
• Net income will be 32 percent of sales.
• Investment in fixed assets will be 35 percent of sales; investment in working capital
will be 6 percent of sales; depreciation will be 9 percent of sales.
• 20 percent of the investment in assets will be financed with debt.
• Interest expenses will be only 2 percent of sales.
• The tax rate will be 10 percent. TMI Manufacturing’s beta is 2.1; the risk-free govern-
ment bond rate is 6.4 percent; the equity risk premium is 5.0 percent.
• At the end of 2013, Johnston projects TMI will sell for 18 times earnings.
What is the value of one ordinary share of TMI Manufacturing Company?
7. Do Pham is evaluating Phaneuf Accelerateur by using the FCFF and FCFE valuation
approaches. Pham has collected the following information (currency in euro):
• Phaneuf has net income of €250 million, depreciation of €90 million, capital expendi-
tures of €170 million, and an increase in working capital of €40 million.
• Phaneuf will finance 40 percent of the increase in net fixed assets (capital expendi-
tures less depreciation) and 40 percent of the increase in working capital with debt
financing.
• Interest expenses are €150 million. The current market value of Phaneuf ’s outstanding
debt is €1,800 million.

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 200 Equity Asset Valuation

• FCFF is expected to grow at 6.0 percent indefinitely, and FCFE is expected to grow at
7.0 percent.
• The tax rate is 30 percent.
• Phaneuf is financed with 40 percent debt and 60 percent equity. The before-tax cost
of debt is 9 percent, and the before-tax cost of equity is 13 percent.
• Phaneuf has 10 million outstanding shares.
A. Using the FCFF valuation approach, estimate the total value of the firm, the total
market value of equity, and the per-share value of equity.
B. Using the FCFE valuation approach, estimate the total market value of equity and
the per-share value of equity.
8. PHB Company currently sells for $32.50 per share. In an attempt to determine whether
PHB is fairly priced, an analyst has assembled the following information:
• The before-tax required rates of return on PHB debt, preferred stock, and common
stock are, respectively, 7.0 percent, 6.8 percent, and 11.0 percent.
• The company’s target capital structure is 30 percent debt, 15 percent preferred stock,
and 55 percent common stock.
• The market value of the company’s debt is $145 million, and its preferred stock is val-
ued at $65 million.
• PHB’s FCFF for the year just ended is $28 million. FCFF is expected to grow at a
constant rate of 4 percent for the foreseeable future.
• The tax rate is 35 percent.
• PHB has 8 million outstanding common shares.
What is PHB’s estimated value per share? Is PHB’s stock underpriced?
9. Watson Dunn is planning to value BCC Corporation, a provider of a variety of indus-
trial metals and minerals. Dunn uses a single-stage FCFF approach. The financial infor-
mation Dunn has assembled for his valuation is as follows:
• The company has 1,852 million shares outstanding.
• The market value of its debt is $3.192 billion.
• The FCFF is currently $1.1559 billion.
• The equity beta is 0.90; the equity risk premium is 5.5 percent; the risk-free rate is 5.5
percent.
• The before-tax cost of debt is 7.0 percent.
• The tax rate is 40 percent.
• To calculate WACC, he will assume the company is financed 25 percent with debt.
• The FCFF growth rate is 4 percent.
Using Dunn’s information, calculate the following:
A. WACC.
B. Value of the firm.
C. Total market value of equity.
D. Value per share.
10. Kenneth McCoin is valuing McInish Corporation and performing a sensitivity analysis
on his valuation. He uses a single-stage FCFE growth model. The base-case values for
each of the parameters in the model are given, together with possible low and high esti-
mates for each variable, in the following table.

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 Chapter 4 Free Cash Flow Valuation 201

Variable Base-Case Value Low Estimate High Estimate

Normalized FCFE0 $0.88 $0.70 $1.14
Risk-free rate 5.08% 5.00% 5.20%
Equity risk premium 5.50% 4.50% 6.50%
Beta 0.70 0.60 0.80
FCFE growth rate 6.40% 4.00% 7.00%

A. Use the base-case values to estimate the current value of McInish Corporation.
B. Calculate the range of stock prices that would occur if the base-case value for FCFE0
were replaced by the low estimate and the high estimate for FCFE0. Similarly, using
the base-case values for all other variables, calculate the range of stock prices caused
by using the low and high values for beta, the risk-free rate, the equity risk pre-
mium, and the growth rate. Based on these ranges, rank the sensitivity of the stock
price to each of the five variables.
11. An aggressive financial planner who claims to have a superior method for picking underval-
ued stocks is courting one of your clients. The planner claims that the best way to find the
value of a stock is to divide EBITDA by the risk-free bond rate. The planner is urging your
client to invest in NewMarket, Inc. The planner says that NewMarket’s EBITDA of $1,580
million divided by the long-term government bond rate of 7 percent gives a total value
of $22,571.4 million. With 318 million outstanding shares, NewMarket’s value per share
found by using this method is $70.98. Shares of NewMarket currently trade for $36.50.
A. Provide your client with an alternative estimate of NewMarket’s value per share
based on a two-stage FCFE valuation approach. Use the following assumptions:
• Net income is currently $600 million. Net income will grow by 20 percent annu-
ally for the next three years.
• The net investment in operating assets (capital expenditures less depreciation plus
investment in working capital) will be $1,150 million next year and grow at 15
percent for the following two years.
• Forty percent of the net investment in operating assets will be financed with net
new debt financing.
• NewMarket’s beta is 1.3; the risk-free bond rate is 7 percent; the equity risk pre-
mium is 4 percent.
• After three years, the growth rate of net income will be 8 percent and the net
investment in operating assets (capital expenditures minus depreciation plus
increase in working capital) each year will drop to 30 percent of net income.
• Debt is, and will continue to be, 40 percent of total assets.
• NewMarket has 318 million shares outstanding.
B. Criticize the valuation approach that the aggressive financial planner used.
12. Bron has EPS of $3.00 in 2002 and expects EPS to increase by 21 percent in 2003.
Earnings per share are expected to grow at a decreasing rate for the following five years,
as shown in the following table.
2003 2004 2005 2006 2007 2008
Growth rate for EPS 21% 18% 15% 12% 9% 6%
Net capital expenditures per share $5.00 $5.00 $4.50 $4.00 $3.50 $1.50

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 202 Equity Asset Valuation

In 2008, the growth rate will be 6 percent and is expected to stay at that rate thereafter.
Net capital expenditures (capital expenditures minus depreciation) will be $5.00 per share
in 2002 and then follow the pattern predicted in the table. In 2008, net capital expendi-
tures are expected to be $1.50 and will then grow at 6 percent annually. The investment
in working capital parallels the increase in net capital expenditures and is predicted to
equal 25 percent of net capital expenditures each year. In 2008, investment in working
capital will be $0.375 and is predicted to grow at 6 percent thereafter. Bron will use debt
financing to fund 40 percent of net capital expenditures and 40 percent of the investment
in working capital. The required rate of return for Bron is 12 percent.
Estimate the value of a Bron share using a two-stage FCFE valuation approach.
13. The management of Telluride, an international diversified conglomerate based in the
United States, believes that the recent strong performance of its wholly owned medi-
cal supply subsidiary, Sundanci, has gone unnoticed. To realize Sundanci’s full value,
Telluride has announced that it will divest Sundanci in a tax-free spin-off.
Sue Carroll, CFA, is director of research at Kesson and Associates. In developing an
investment recommendation for Sundanci, Carroll has gathered the information shown
in Exhibits 4-19 and 4-20.
EXHIBIT 4-19 Sundanci Actual 2007 and 2008 Financial Statements for Fiscal Years
Ending 31 May (dollars in millions except per-share data)

Income Statement 2007 2008

Revenue $474 $598
Depreciation 20 23
Other operating costs 368 460
Income before taxes 86 115
Taxes 26 35
Net income 60 80
Dividends 18 24
EPS $0.714 $0.952
Dividends per share $0.214 $0.286
Common shares outstanding 84.0 84.0
Balance Sheet 2007 2008
Current assets (includes $5 cash in 2007 and 2008) $201 $326
Net property, plant, and equipment 474 489
Total assets 675 815
Current liabilities (all non-interest-bearing) 57 141
Long-term debt 0 0
Total liabilities
Shareholders’ equity 618 674
Total liabilities and equity 675 815
Capital expenditures 34 38

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 Chapter 4 Free Cash Flow Valuation 203

EXHIBIT 4-20 Selected Financial Information

Required rate of return on equity 14%
Industry growth rate 13%
Industry P/E 26

Abbey Naylor, CFA, has been directed by Carroll to determine the value of Sundanci’s
stock by using the FCFE model. Naylor believes that Sundanci’s FCFE will grow at 27
percent for two years and at 13 percent thereafter. Capital expenditures, depreciation,
and working capital are all expected to increase proportionately with FCFE.
A. Calculate the amount of FCFE per share for 2008 by using the data from Exhibit 4-19.
B. Calculate the current value of a share of Sundanci stock based on the two-stage
FCFE model.
C. Describe limitations that the two-stage DDM and FCFE models have in common.
14. John Jones, CFA, is head of the research department of Peninsular Research. One of the com-
panies he is researching, Mackinac Inc., is a U.S.-based manufacturing company. Mackinac
has released the June 2007 financial statements shown in Exhibits 4-21, 4-22, and 4-23.

EXHIBIT 4-21 Mackinac Inc. Annual Income Statement

30 June 2007 (in thousands, except per-share data)
Sales $250,000
Cost of goods sold 125,000
Gross operating profit 125,000
Selling, general, and administrative expenses 50,000
EBITDA 75,000
Depreciation and amortization 10,500
EBIT 64,500
Interest expense 11,000
Pretax income 53,500
Income taxes 16,050
Net income $37,450
Shares outstanding 13,000
EPS $2.88

EXHIBIT 4-22 Mackinac Inc. Balance Sheet 30 June 2007 (in thousands)
Current Assets
Cash and equivalents $20,000
Receivables 40,000
Inventories 29,000

(Continued)

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 204 Equity Asset Valuation

EXHIBIT 4-22 (Continued )

Current Assets
Other current assets 23,000
Total current assets $112,000
Noncurrent Assets
Property, plant, and equipment $145,000
Less: Accumulated depreciation 43,000
Net property, plant, and equipment 102,000
Investments 70,000
Other noncurrent assets 36,000
Total noncurrent assets 208,000
Total assets $320,000
Current Liabilities
Accounts payable $41,000
Short-term debt 12,000
Other current liabilities 17,000
Total current liabilities $70,000
Noncurrent Liabilities
Long-term debt 100,000
Total noncurrent liabilities 100,000
Total liabilities 170,000
Shareholders’ Equity
Common equity 40,000
Retained earnings 110,000
Total equity 150,000
Total liabilities and equity $320,000

EXHIBIT 4-23 Mackinac Inc. Cash Flow Statement 30 June 2007 (in thousands)
Cash Flow from Operating Activities
Net income $37,450
Depreciation and amortization 10,500
Change in Working Capital
(Increase) decrease in receivables ($5,000)
(Increase) decrease in inventories (8,000)
Increase (decrease) in payables 6,000
Increase (decrease) in other current liabilities 1,500

(Continued )

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 Chapter 4 Free Cash Flow Valuation 205

EXHIBIT 4-23 (Continued )

Net change in working capital (5,500)
Net cash from operating activities $42,450
Cash Flow from Investing Activities
Purchase of property, plant, and equipment ($15,000)
Net cash from investing activities ($15,000)
Cash Flow from Financing Activities
Change in debt outstanding $4,000
Payment of cash dividends (22,470)
Net cash from financing activities (18,470)
Net change in cash and cash equivalents $8,980
Cash at beginning of period 11,020
Cash at end of period $20,000

Mackinac has announced that it has finalized an agreement to handle North American
production of a successful product currently marketed by a company headquartered out-
side North America. Jones decides to value Mackinac by using the DDM and FCFE
models. After reviewing Mackinac’s financial statements and forecasts related to the new
production agreement, Jones concludes the following:
• Mackinac’s earnings and FCFE are expected to grow 17 percent a year over the next
three years before stabilizing at an annual growth rate of 9 percent.
• Mackinac will maintain the current payout ratio.
• Mackinac’s beta is 1.25.
• The government bond yield is 6 percent, and the market equity risk premium is 5 percent.
A. Calculate the value of a share of Mackinac’s common stock by using the two-stage DDM.
B. Calculate the value of a share of Mackinac’s common stock by using the two-stage
FCFE model.
C. Jones is discussing with a corporate client the possibility of that client acquiring a 70
percent interest in Mackinac. Discuss whether the DDM or FCFE model is more
appropriate for this client’s valuation purposes.
15. SK Telecom Company is a cellular telephone paging and computer communication ser-
vices company in Seoul, South Korea. The company is traded on the Korea, New York,
and London stock exchanges (NYSE: SKM). Sol Kim has estimated the normalized FCFE
for SK Telecom to be 1,300 Korean won (per share) for the year just ended. The real coun-
try return for South Korea is 6.50 percent. To estimate the required return for SK Telecom,
Kim makes the following adjustments to the real country return: an industry adjustment
of 0.60 percent, a size adjustment of –0.10 percent, and a leverage adjustment of 0.25
percent. The long-term real growth rate for South Korea is estimated to be 3.5 percent,
and Kim expects the real growth rate of SK Telecom to track the country rate.
A. What is the real required rate of return for SK Telecom?
B. Using the single-stage FCFE valuation model and real values for the discount rate
and FCFE growth rate, estimate the value of one share of SK Telecom.

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 206 Equity Asset Valuation

16. Lawrence McKibben is preparing a valuation of QuickChange Auto Centers, Inc.

McKibben has decided to use a three-stage FCFE valuation model and the following
estimates. The FCFE per share for the current year is $0.75. The FCFE is expected to
grow at 10 percent for next year, then at 26 percent annually for the following three
years, and then at 6 percent in year 5 and thereafter. QuickChange’s estimated beta is
2.00, and McKibben believes that current market conditions dictate a 4.5 percent risk-
free rate of return and a 5.0 percent equity risk premium. Given McKibben’s assump-
tions and approach, estimate the value of a share of QuickChange.
17. Clay Cooperman has valued the operating assets of Johnson Extrusion at $720 million.
The company also has short-term cash and securities with a market value of $60 mil-
lion that are not needed for Johnson’s operations. The noncurrent investments have a
book value of $30 million and a market value of $45 million. The company also has an
overfunded pension plan, with plan assets of $210 million and plan liabilities of $170
million. Johnson Extrusion has $215 million of notes and bonds outstanding and 100
million outstanding shares. What is the value per share of Johnson Extrusion stock?
Use the following information to answer Questions 18 through 23.
Ryan Leigh is preparing a presentation that analyzes the valuation of the common stock of two
companies under consideration as additions to his firm’s recommended list, Emerald Corpo-
ration and Holt Corporation. Leigh has prepared preliminary valuations of both companies
using an FCFE model and is also preparing a value estimate for Emerald using a dividend
discount model. Holt’s 2007 and 2008 financial statements, contained in Exhibits 4-24 and
4-25, are prepared in accordance with U.S. GAAP.

EXHIBIT 4-24 Holt Corporation Consolidated Balance Sheets (US$ millions)

As of 31 December
2008 2007
Assets
Current assets
Cash and cash equivalents $372 $315
Accounts receivable 770 711
Inventories 846 780
Total current assets 1,988 1,806
Gross fixed assets 4,275 3,752
Less: Accumulated depreciation 1,176 3,099 906 2,846
Total assets $5,087 $4,652
Liabilities and shareholders’ equity
Current liabilities
Accounts payable $476 $443
Accrued taxes and expenses 149 114
Notes payable 465 450

(Continued)

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 Chapter 4 Free Cash Flow Valuation 207

EXHIBIT 4-24 (Continued )

As of 31 December
2008 2007
Total current liabilities 1,090 1,007
Long-term debt 1,575 1,515
Common stock 525 525
Retained earnings 1,897 1,605
Total liabilities and shareholders’ equity $5,087 $4,652

EXHIBIT 4-25 Holt Corporation Consolidated Income Statement for the Year Ended
31 December 2008 (US$ millions)

Total revenues $3,323

Cost of goods sold 1,287
Selling, general, and administrative expenses 858
Earnings before interest, taxes, depreciation,
and amortization (EBITDA) 1,178
Depreciation expense 270
Operating income 908
Interest expense 195
Pretax income 713
Income tax (at 32 percent) 228
Net income $485

Leigh presents his valuations of the common stock of Emerald and Holt to his supervi-
sor, Alice Smith. Smith has the following questions and comments:

• “I estimate that Emerald’s long-term expected dividend payout rate is 20 percent and its
return on equity is 10 percent over the long-term.”
• “Why did you use an FCFE model to value Holt’s common stock? Can you use a DDM
instead?”
• “How did Holt’s FCFE for 2008 compare with its FCFF for the same year? I recommend
you use an FCFF model to value Holt’s common stock instead of using an FCFE model
because Holt has had a history of leverage changes in the past.”
• “In the past three years, about 5 percent of Holt’s growth in FCFE has come from decreases
in inventory.”
Leigh responds to each of Smith’s points as follows:
• “I will use your estimates and calculate Emerald’s long-term, sustainable dividend growth
rate.”
• “There are two reasons why I used the FCFE model to value Holt’s common stock instead
of using a DDM. The first reason is that Holt’s dividends have differed significantly from its

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 208 Equity Asset Valuation

capacity to pay dividends. The second reason is that Holt is a takeover target and once the
company is taken over, the new owners will have discretion over the uses of free cash flow.”
• “I will calculate Holt’s FCFF for 2008 and estimate the value of Holt’s common stock
using an FCFF model.”
• “Holt is a growing company. In forecasting either Holt’s FCFE or FCFF growth rates,
I will not consider decreases in inventory to be a long-term source of growth.”

18. Which of the following long-term FCFE growth rates is most consistent with the facts
and stated policies of Emerald?
A. 5 percent or lower.
B. 2 percent or higher.
C. 8 percent or higher.
19. Do the reasons provided by Leigh support his use of the FCFE model to value Holt’s
common stock instead of using a DDM?
A. Yes.
B. No, because Holt’s dividend situation argues in favor of using the DDM.
C. No, because FCFE is not appropriate for investors taking a control perspective.
20. Holt’s FCFF (in millions) for 2008 is closest to:
A. $308.
B. $370.
C. $422.
21. Holt’s FCFE (in millions) for 2008 is closest to:
A. $175.
B. $250.
C. $364.
22. Leigh’s comment about not considering decreases in inventory to be a source of long-
term growth in free cash flow for Holt is:
A. Inconsistent with a forecasting perspective.
B. Mistaken because decreases in inventory are a use rather than a source of cash.
C. Consistent with a forecasting perspective because inventory reduction has a limit,
particularly for a growing firm.
23. Smith’s recommendation to use an FCFF model to value Holt is:
A. Logical, given the prospect of Holt changing capital structure.
B. Not logical because an FCFF model is used only to value the total firm.
C. Not logical because FCFE represents a more direct approach to free cash flow
valuation.

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