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Chapter 11

Corporate Valuation Based on Free Cash

Flows (FCF)

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Corp. Valuation Based on Free Cash Flows (FCF) The Free Cash Flow Valuation

model can be applied to a firm that does not pay dividends, a privately held firm, or to a division of a firm.

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What is free cash flow (FCF) & why is it important? FCF is the cash from operations

available for distribution to investors (stockholders and debtholders) after making the necessary investments to support operations.

A company’s value depends upon the amount of FCF it can generate.

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Free Cash Flow Valuation The FCF approach estimates total

enterprise value, rather than the value of equity or per share value directly.

The value of equity (& per share value) can be obtained from the total value by netting out other claims.

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Data for Valuation FCF0 = $20 million WACC = 10% g = 5% Marketable securities = $100 million Debt = $200 million Preferred stock = $50 million Book value of equity = $210 million

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Constant Growth Formula If the growth rate is constant:

VOp = FCF1

(WACC - g)

= FCF0(1+g)(WACC - g)

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Find Value of Operations

VOp = FCF0 (1 + g)(WACC - g)

VOp = 20(1+0.05)(0.10 – 0.05)

= 420

Total Corporate Value Total corporate value is sum of:

Value of operations (VOP) Value of nonoperating assets

Total Corp Value = VOP + Mkt Sec = $420 + $100 = $520 mil

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Claims on Corporate Value Debtholders have first claim. Preferred stockholders have the

next claim. Any remaining value belongs to

common stockholders.

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Value of Equity Total corporate value = VOp + Mkt. Sec.

= $420 + $100 = $520 million

Com equity value = Total - Debt - Pref. = $520 - $200 - $50

= $270 million

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Per Share Value To get value per share, divide the

value of common equity by the number of shares.

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Horizon Value If the expected growth in free cash

flows during the forecast period is not constant, we cannot use the constant growth formula to find the value of operations at time 0.

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Horizon Value (cont.) However, if growth is constant

after the planning period, we can find the value at the end of the planning horizon.

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Horizon Value Formula

Horizon value is also called terminal value, or continuing value.

VOp at time t = FCFt(1+g)(WACC - g)

HV =

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Value of Operations with non-constant Growth If growth is non-constant, the

value of operations at t = 0 is the PV of FCFs during the planning period, plus the PV of the horizon value, all discounted at the WACC.