Value of Firm
FCFF / 1 + WACC
Value of Equity
Value of Firm (-) Mkt Debt value {use for levered company with negative FCFE or levered company with changing capital structure} (or) FCFE / 1 + Ke {use for stable cap structure }
Don’t we use g
The above formula are used in assumption that the Co generates CF and then dies. Usually we do the same as in DDM like using G in equation
Adjusted Present Value
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 NPV of any effects of debt on firm value (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)
Use Book or Mkt Value for WACC
Always Mkt Value to assign weight
Growth rate of FCFF & FCFE
need not be same
FCFF
NI available to common shareholders + NCC + Int (1-t) - WC - FC = EBIT(1-T) + NCC - WC - FC = EBITDA(1-T) + Dep*T - WC - FC. NI represent income after payment of dividend to preferred SH but before payt to common SH
Dividend on pref stock
should be added back as it is a cash flow for one of Co cap providers
FC Investment represent
net amount = Outflow - Inflow
If Co treats interest expenses as part of CFO & qn gives CFO
add back Int*(1-T) becoz it was not added back while calculating CFO
Deferred tax
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 liability, 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.
DTA
means in P&L we have added back deferred tax to derive net income. So while calculating FCFF subtract that amount from net income. If, however, the deferred tax asset is expected to reverse in the near future, 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.
FCFE
FCFF - Int*(1-T) + Net Borrowing
Earnings are more volatile than dividend
Reason being companies raise dividends slowly even when their earnings are increasing rapidly, and companies often maintain their current dividends even when their profitability has declined.
Forecasting of FCFF components
Assumptions like Investment in fixed capital in excess of depreciation and investment in working capital both bear a constant relationship to forecast increases in the size of the company as measured by increases in sales.
Forecasting of FCFE components
Assume that the capital structure represented by the debt ratio (debt as a % of debt plus equity) is constant. Under that assumption, 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.
Capex has 2 components
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 target debt ratio is assumed
We assume that a specified percentage of the sum of (1) net new investment in fixed capital (new fixed capital minus depreciation expense) and (2) the increase in working capital is financed based on a target DR. This assumption leads to a simplification of FCFE calculations. Net borrowing = DR(FCInv – Dep) + DR(WCInv).
Factors that cause discrepancies between change in BS accounts & changes reported in CF statement
acquisitions or divestitures (and related discontinued operations) and the presence of nondomestic subsidiaries. For example, an increase in an inventory account may result from purchases 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.
What does & doesn’t affect FCFF & FCFE
Cash dividend payment, share repurchase of common stock, issue of common stock - no effect on both. Increasing leverage - no effect on FCFF. In the year the debt is issued, FCFE increases by the amount of debt issued. After the debt is issued, FCFE is then reduced by the after-tax interest expense
Required rate of return (real)
Country return (real) +/- Industry adj +/- size adj +/- leverage adj. if Real disc rate & real growth rate can be estimated more reliably use this
PV of terminal value is substantial portion of total stock value
in both FCF & DDM model
