Class 11 – Free Cash Flows

Corporate Finance (15.425) – David THESMAR

Valuation: goals and methods

• Two types of valuation objectives:

• Projects, aka “capital budgeting”
• Firms

• Several types of methods

• Multiples, IRR, Payback
• DCF: this class
• WACC, FTE, APV → later (builds on DCF)

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Corporate Finance (15.425) – David THESMAR
Evidence from Capital Budgeting Practices:
People really use DCF
• John Graham has run surveys among CFOs since the early 2000s

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Corporate Finance (15.425) – David THESMAR
The DCF Approach

FCF
Project value = debt + equity =
1+Discount rate

• FCF: expected after tax cash flows of an all equity project

• No adjustment for risk there (mathematical expectation)
• No interest payment: all of the project’s cash-flows
• No tax shield of debt (does not depend on leverage)
→ This class
• Discount rate: expected return from owning the entire project
• Accounts for risk exposure (riskier projects command higher returns)
• Risk of owning all of the cash-flows (debt & equity)
• Accounts for tax shield of debt (depends on leverage)
→ Later class on the “cost of capital”

Corporate Finance (15.425) – David THESMAR 4

Plan of attack

1. Computing cash-flows – accounting & economic assumptions

2. Terminal value

3. In-class example

4. Forecasting cash-flows – lessons from behavioral economics

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Corporate Finance (15.425) – David THESMAR
Plan of attack

1. Computing cash-flows – accounting & economic assumptions

2. Terminal value

3. In-class example

4. Forecasting cash-flows – lessons from behavioral economics

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Corporate Finance (15.425) – David THESMAR
FCF: the goal

• What we need = free cash-flows of the all-equity project

• Because we want the value of the entire project, not just equity
• So no deduction of interest payments!

• We need to forecast future cash flows

• To make this a bit easier, we forecast accounting profits & investment
• Assumptions about revenue growth
• Assumptions about margins
• Assumptions about investment

➔ Need a mapping btw accounting profits & cash flows →

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Corporate Finance (15.425) – David THESMAR
Accounting Formula(s)

FCF = (1-t) x EBIT + DEP – CAPX – NWC

equivalent to:
FCF = (1-t) x EBITDA + t x DEP – CAPX – NWC
equivalent to:
FCF = (1-t) x EBIT –  Net Assets

Note:
NWC = Acc. Rec. + Inventories – Acc. Pay.
NWC is sometimes called Investment in NWC
Net Assets = PP&E + NWC

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Corporate Finance (15.425) – David THESMAR
 cash-flows formulas: remarks

• predicting FCF will be (relatively) simple:

• Predict EBIT (make assumption on operating margin & sales growth)
• Predict change in assets (CAPX and WC needs)

• No tax shield of debt, but tax shield of DEP!

• Term in t x DEP in the second formula
• CAPX is “expensed” over several periods
• Question: do companies prefer fast or slow depreciation schedule?

Corporate Finance (15.425) – David THESMAR 9

 cash-flows formulas: remarks

• predicting FCF will be (relatively) simple:

• Predict EBIT (make assumption on operating margin & sales growth)
• Predict change in assets (CAPX and WC needs)

• No tax shield of debt, but tax shield of DEP!

• Term in t x DEP in the second formula
• CAPX is “expensed” over several periods
• Question: do companies prefer fast or slow depreciation schedule?

• Fast of course, it increases the PV of the depreciation tax shield

• In times of crises, U.S. congress passes accelerated depreciation
• It benefits industries with slow depreciation (long duration assets) more

Corporate Finance (15.425) – David THESMAR 10

 relevant cash-flows: economic principles

• include all cost items

• Building fixed assets (CAPX) or inventories/trade credit (NWC) are both costs
• Opportunity costs are true costs

• include incremental cash flows only

• CFs (<0 or >0) which would not have occurred without the project
• Sunk costs are not costs

• be consistent in your treatment of inflation:

• Discount nominal cash flows at nominal discount rates
(Or: real cash flows with real discount rates, but people never do this)

Corporate Finance (15.425) – David THESMAR 11

An example of FCF calculation: Sell-side
analyst reports
• Analysts use DCF to value firms
• “price targets”, buy/sell recommendation, ratings, etc
• Sometimes also use multiples

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Corporate Finance (15.425) – David THESMAR
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Corporate Finance (15.425) – David THESMAR
Plan of attack

1. Computing cash-flows – accounting & economic assumptions

2. Terminal value

3. In-class example

4. Forecasting cash-flows – lessons from behavioral economics

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Corporate Finance (15.425) – David THESMAR
Terminal Value

• Forecast FCF until some terminal date T

• Optimal # years depends on project
• Tech firms → multiples, short horizon
• Mature firms, industrials → longer horizon

• At the end of T, need for a terminal value. Three options:

• Liquidation
• Mostly for projects, get rid of capital stock, of inventory, pay trade creditors
• FCF is a growing perpetuity
• Mostly for firms
• Multiple
• Mostly for firms

Corporate Finance (15.425) – David THESMAR 15

Terminal Value with liquidation
• Post tax cash-flows:

SV- t*(SV-PPE) + WC = SV *(1- t) + t*PPE + WC

• SV = salvage value = liquidation value – liquidation costs (“net sale price”)

• PPE = remaining PPE tied to project
• WC = remaining working capital

• Intuition
• Remaining PPE depreciated to zero → depreciation tax shield
• Liquidation costs assumed tax deductible
• Implicitly assumes marginal tax rate = t
• WC not taxed (taxed via income)
• sometimes, not all WC is recouped (e.g. , lost A/R)

Corporate Finance (15.425) – David THESMAR 16

Terminal Value as Growing Perpetuity
• After last date of cash-flows T, FCF write, for all k>0:

FCFT+k = EBITT+k(1-t) + DepreciationT+k – CAPXT+k – NWCT+k

-NAT+k

• Assume EBIT and NA both grow at rate g

→ FCF grow at g every year after T

➔ PV as of T with discount rate r is given by perpetuity formula:

TVT = FCFT+1/(r-g) = ((1-t)(1+g)EBITT – g NAT) /(r – g)

Corporate Finance (15.425) – David THESMAR 17

Remark on TV

• In firm valuation, TV is a big fraction of total value (remember SAP!)

• Projects, who are terminated, do not have this problem
• But firms are forever, here are more cash flows after T than before.
• Of course, long-term cash flows are more severely discounted, but still:

• To visualize this, assume:

• Next year’s FCF = E, then grows at rate g in perpetuity
• discount rate r
→Firm worth P = E/(r-g)
• Present Value of TV in T years = [(1+g)/(1+r)]T x P

• For instance: g=2%, r=10%, T=10 → 47% of value = terminal value

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Corporate Finance (15.425) – David THESMAR
Terminal Value as Multiple

VT = (EBIT multiple) x EBITT

• EBIT multiple = average (ET+DT)/EBITT of comparables

• EBIT multiple controls for leverage effect

• firms with identical operations should have the same EBIT multiple
• Even if different capital structure
• In real world, taxes, CFDs will affect the multiple
• But we neglect that

• Variants: EBITDA multiple, sales multiples etc.

Corporate Finance (15.425) – David THESMAR 19

Terminal value: what do analysts do?
Evidence from 80,000 analyst reports by Décaire and Graham

Terminal growth rate g: 3% 2% Forecast horizon T=3 or 10

Also: terminal value as % of total DCF = 70% (on average)

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Corporate Finance (15.425) – David THESMAR
Forecast Horizon in capital budgeting
Evidence from Graham’s CFO survey
• In capital budgeting, T has gone down from 5 to 3 since 2000

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Corporate Finance (15.425) – David THESMAR
Forecast Horizon in capital budgeting
Association of Finance Professionals survey
• There is quite a bit of variation
• Most often: 5 years or 10 years

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Corporate Finance (15.425) – David THESMAR
Plan of attack

1. Computing cash-flows – accounting & economic assumptions

2. Terminal value

3. In-class example

4. Forecasting cash-flows – lessons from behavioral economics

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Corporate Finance (15.425) – David THESMAR
In-class exercise
• XYZ, a profitable widget producer ($100M annual after-tax profit) contemplates introducing
new Turbo Widgets (TWs), developed in its labs at an R&D cost of $1M over the past 3 years.
• New plant to produce TW would
→ cost $20M today
→ last 10 years with salvage value of $5M
→ be depreciated to $0 over 5 years using straight-line depreciation
• TWs need painting: Use 40% of the capacity of a painting machine
→ currently owned and used by XYZ at 30% capacity
→ with maintenance costs of $100,000 (regardless of capacity used)
• Operation costs and revenues
→operating expenses (excl. depreciation): $400,000
→revenue: $42M
→EBIT from sales of regular widgets would decrease by $2M
• Working capital (WC): $2M needed over the life of the project
• Corporate tax rate 36%

calculate all FCF of this project

Corporate Finance (15.425) – David THESMAR 24

TW Example (cont.)
Which of the following items are relevant to evaluate the project?

• $100M after-tax profit

• R&D cost of $1M over the past three years

• The plant’s $20M cost

• Machine’s $100K maintenance cost

• Operating income from regular widgets decreases by $2M

Corporate Finance (15.425) – David THESMAR 25

TW Example (cont.)
• Ignore the $100M after-tax profit and focus on incremental cash flows

• R&D cost of $1M over the past three years: Sunk cost ==> Ignore it

• The plant’s $20M cost: It’s a CAPX ==> Count it

• Machine’s $100K maintenance cost: Not incremental ==> Ignore it

• Incurred with or without TW production
• True even if accounting charges TW production a fraction of these

• Operating income from widgets decreases by $2M due to cannibalization

• Would not occur without TW production
• It is an opportunity cost ==> Count it

Corporate Finance (15.425) – David THESMAR 26

TW Example (cont.)
• Depreciation:
→Straight line depreciation: Flat annual depreciation
→Accelerated depreciation: Decreasing

• $20M CAPX is depreciated linearly over 5 years, down to zero.

D = (20 - 0) / 5 = $4M

• Salvage value of $5M is fully taxable since book value is zero.

Year 0 1 2 3 4 5 6 7 8 9 10
CAPX 20 0 0 0 0 0 0 0 0 0 0
Depreciation 0 4 4 4 4 4 0 0 0 0 0
Salvage Value 0 0 0 0 0 0 0 0 0 0 5

Corporate Finance (15.425) – David THESMAR 27

TW Example (end)

Here: Liq value + PV of DEP tax shield = 5% of value

Corporate Finance (15.425) – David THESMAR 28

Plan of attack

1. Computing cash-flows – accounting & economic assumptions

2. Terminal value

3. In-class example

4. Forecasting cash-flows – lessons from behavioral economics

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Corporate Finance (15.425) – David THESMAR
Forecasting cash-flows right
lessons from behavioral economics
• Expected cash flows in DCF
• best possible forecast given information (lowest mean squared error)
• i.e. mathematical expectation E, i.e. “rational expectations”
• Properly discounted, you get the present value

• Problem: Humans struggle to form such rational forecasts

• Bias: humans make predictable errors
• Overreaction/underreaction to news
• Noise: human add unpredictable “noise”

→ Both problems matter for valuation

• See examples in next slide

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Corporate Finance (15.425) – David THESMAR
Effect of biases in expected FCF on stock
market valuations
Market overreaction to COVID Market underreaction to news
compared to analyst forecasts about a biotech

Corporate Finance (15.425) – David THESMAR

How to make FCF expectations more rational

• Be aware of bias & noise, use your judgment:

• Assuming project will always be at 100% capacity ≠ mathematical expectation

• When possible, collect data & do statistics

• Investors make a lot of similar decisions: Hedge funds, but also biotechs
• Firms make a lot of similar investment decisions
• Collect data on subjective forecasting itself + corresponding realizations
• Human judgment is flawed but processes unstructured information
• Statistical analysis is a complement to human judgment, not a substitute

• Use organization to attenuate bias and noise in forecasts

• Wisdom of crowds: groups are less “noisy” than individuals
• Rules may be too rigid, but have no noise
• Leverage “superforecasters”, try teamwork, give feedback, recalibrate
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Corporate Finance (15.425) – David THESMAR
conclusion

• DCF valuation: Project value = FCF / (1+discount rate)

• FCF = cash-flows of 100% equity project

• Net of taxes and investment in current and fixed assets
• Financing structure does not change FCF
• Once they are forecast, they do not change
• No MM assumption here, this is what people use in practice

• Forecasting: learn from behavioral finance

• Beware of bias & noise
• Collect data, discipline forecasts, leverage wisdom of crowds

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Corporate Finance (15.425) – David THESMAR