Free Cash Flow and Its Uses

Cash Flow
A revenue or expense stream that changes a cash account over a given period.

Classified as :
Operational cash flows: Cash received or expended as a result of the company's internal business activities. Investment cash flows: Cash received from the sale of long-life assets, or spent on capital expenditure.

Financing cash flows: Cash received from the issue of debt and
equity, or paid out as dividends, share repurchases or debt repayments.

 A measure of financial performance calculated as operating

cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base.

Free cash flow is important because it allows a company

to pursue opportunities that enhance shareholder value. FCF is calculated as: EBIT(1-Tax Rate) + Depreciation & Amortization - Change in Net Working Capital - Capital Expenditure

 Free cash flow to equity (FCFE)

The cash flow available to the firms common equity holders after all operating expenses, interest and principal payments have been paid, and necessary investments in working and fixed capital have been made. FCFE = Net Income - Net Capital Expenditure - Change

in Net Working Capital + New Debt - Debt Repayment

 Free Cash Flow For The Firm (FCFF)

A measure of financial performance that expresses the net amount of cash that is generated for the firm, consisting of expenses, taxes and changes in net working capital and investments.

FCFF = EBIT(1 - tax rate) [Capital Expenditure +

Depreciation] - Change in non-cash working capital

Free Cash flow to equity of an unlevered firm

Revenues - Operating expenses

= EBITDA - Depreciation and amortization = EBIT - Taxes = Net income + Depreciation and amortization = operating cash flow - Capital expenses - Change in Working capital = Free cash flow to equity

Free Cash flow to equity of a levered firm

Revenues
- operating expenses = EBITDA - Depreciation and amortization = EBIT - interest expenses

= EBT
- Taxes = Net income + Depreciation and amortization = operating cash flow -Preferred dividends - Capital expenses

- working capital change

- principal repayments +proceeds from new debt issues = Free cash flow to equity

Free Cash flow to firm

Free cash flow to firm =Free cash flow to equity

+ Interest expenses(1- tax rate) +Principal repayments - New debt issues +Preferred dividend OR Free cash flow to firm =EBIT (1- tax rate) +Depreciation - Capital Expenditure - Working capital needs

Applications of Free Cash Flow

1. Constant Growth Model

Best suited for firms growing at a rate comparable
to or lower than the nominal growth in the economy
Better model for firms paying dividends which are

unsustainably high or significantly lower than FCFE.

For a firm paying dividend equal to FCFE the value

obtained would be same as that of Gordon growth

model.

 Assumptions
1. The firm is an all-equity firm and has no debt in its capital structure

2.
3. 4.

Retained earnings is the only source of financing

The internal rate of return is the firms cost of capital K, which remains constant. Future growth rate of FCFE is expected to be constant.

5.
6.

Cost of capital is always greater than the growth rate.

Corporate taxes do not exist.

The model

The value of equity, under the constant growth model, is a function of 1. The expected FCFE in the next period (FCFE1) 2. The stable growth rate (g) 3. The required rate of return (ke)

P0 = FCFE1 / (ke - g)

2. Two Stage Model

1. Designed to value a firm which is expected to grow much faster than a stable firm in the initial period and at a stable rate after that 2. 3. Price of share of a company is determined by its earning

potentiality and investment policy

Given perfect market conditions , FCFE does not affect the market price of the shares

4.

Hence Increase in Shareholders wealth results from

dividend payments will be offset by raising additional capital

Assumptions
1.

Capital markets are perfect

2.
3. 4. 5.

Information is freely available to the investors and

there are no transaction costs The firm has a fixed investment policy There are no taxes or there are uniform taxes Risk or uncertainty does not exist

The model
P0 = FCFE1 / (1+ke)1 + Pn/ (1+ke) n

Where FCFE1 = Free Cash Flow to Equity for 1st year

Pn
Ke

= Price at the end of the extraordinary growth period

= Cost of Equity in high growth(1) and Stable growth periods(n)

3. Three-Stage Free Cash Flow Model

1. 2. The model is designed to value firms that are expected to go through three stages of growth High growth

3.
4.

Transitional period
Steady state period

Calculation is similar to the two-stage model:

Determine the terminal value (at the beginning of mature growth stage)
and discount it together with all preceding free cash flows to the present.

Firm value(V) = [FCFFt / (1 + WACC)t)] + [FCFFt / 1+WACC)n ] + FCFFn+1 / [(WACC - g) (1+WACC)n] : t = 1 to n. Terminal Firm Value = FCFFn+1 / (WACC - g)

Assumptions:
1. Capital Spending versus Depreciation In the high growth phase, capital spending is likely to be much larger than depreciation. In the transitional phase, the difference is likely to narrow. Finally, the difference between capital spending and depreciation will be lower still in stable growth, reflecting the lower expected growth rate. 2. Risk In the context of the CAPM, as the growth rate declines, the beta of the firm can be expected to change. Over time, as these firms get larger and more diversified, the average betas of these portfolios move towards one.

Example
1) FCFF 2002 = $50 million. 2) Market value of debt = $300 million. 3) Shares outstanding = 40 million. 4) Growth rates: 2003 2003-2004: 30%. 2005-2006: 15% Growth 30% After 2006: 5%. rate 5) WACC = 12%. FCFF(mn) 65

2004
30% 84.5

2005
15% 97.2

2006
15% 111.8

2007
5% 117.4

Compute equity value

Firm value(V) = FCFFt / (1 + WACC)t) + *FCFFt + FCFFn+1 / [(WACC - g) (1+WACC)n] : t = 1 to n. Terminal Firm Value = FCFFn+1 / (WACC g) 1) TV2006 = $117.4/(0.12 - 0.05) = $1,677 million. 2) V2002 = $65.0/1.121 + $84.5/1.122 + $97.2/1.123 + ($111.8 + $1,677)/1.124 = $1,331.4 million. 3) Equity value = $1,331.4 - $300 = $1,031.4 million. 4) Equity value per share = $1,031.4 / 40 = $25.78.

Free Cash Flow Vs Dividend

Free cash flows are the cash flows available for

distribution
Dividends are the cash flows actually paid to

stockholders
Difference between Free Cash Flow to Equity

and Dividend paid varies as per industries and

firms.

External and Internal factors

External Factors
State of Economy

State of capital market

Tax Policy

Internal Factors
Liquidity Position Desire of Control

Nature of Earnings
Desire of Shareholders

University Qs
1. Write short note on Free Cash Flow. 2. Discuss concept of free cash flow and describe process of its computation.

Thank you