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LOS 42.a

SS 12

Define and interpret free cash flow to the firm (FCFF) and free cash flow to equity (FCFE).

Level 2

© 2008, Kaplan Schweser

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LOS 42.a

Free cash flow to the firm (FCFF) is the cash available to all of the firm's investors, including stockholders, bondholders, and preferred stockholders after the firm buys and sell products, provides services, pays its operating expenses, and makes short and long-term investments. Free cash flow to equity (FCFE) is the cash available to stockholders after funding capital requirements, working capital needs, and debt financing requirements.

Level 2

© 2008, Kaplan Schweser

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LOS 42.b

SS 12

Describe, compare, and contrast the FCFF and FCFE approaches to valuation.

Level 2

© 2008, Kaplan Schweser

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LOS 42.b

The value of the firm is the present value of the expected future FCFF discounted at the WACC: Firm value = FCFF discounted at the WACC The value of the firm's equity is the present value of the expected future FCFE discounted at the required return on equity: Equity value = FCFE discounted at the required return on equity The differences between FCFF and FCFE account for differences in capital structure and consequently reflect the perspectives of different capital suppliers. FCFE is easier and more straightforward to use in cases where the company's capital structure is not particularly volatile. On the other hand, if a company has negative FCFE and significant debt outstanding, FCFF is generally the best choice. We can always estimate equity value indirectly by discounting FCFF to find firm value and then subtracting out the market value of debt to arrive at equity value.

Level 2

© 2008, Kaplan Schweser

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LOS 42.c

SS 12

Contrast the ownership perspective implicit in the FCFE approach to the ownership perspective implicit in the dividend discount approach.

Level 2

© 2008, Kaplan Schweser

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LOS 42.c

The ownership perspective in the free cash flow approach is that of an acquirer who can change the firm's dividend policy, which is a control perspective. The ownership perspective implicit in the dividend discount approach is that of a minority owner who has no direct control over the firm's dividend policy. If investors are willing to pay a premium for control of the firm, there may be a difference between the values of the same firm derived using the two models. Analysts often prefer to use free cash flow rather than dividend-based valuation for the following reasons: Many firms pay no, or low, cash dividends. Dividends are paid at the discretion of the board of directors. It may, consequently, poorly reflect the firm's long-run profitability. If a company is viewed as an acquisition target, free cash flow is a more appropriate measure because the new owners will have discretion over its distribution.

Level 2

© 2008, Kaplan Schweser

Card 73 of 158

LOS 42.d

SS 12

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.

Level 2

© 2008, Kaplan Schweser

Card 74 of 158

LOS 42.d

FCFF = NI + NCC + [Int × (1 ­ tax rate)] ­ FCInv ­ WCInv FCFF = [EBIT × (1 ­ tax rate)] + Dep ­ FCInv ­ WCInv FCFF = [EBITDA × (1 ­ tax rate)] + (Dep × tax rate) ­ FCInv ­ WCInv FCFF = CFO + [Int × (1 ­ tax rate)] ­ FCInv FCFE = FCFF ­ [Int × (1 ­ tax rate)] + net borrowing FCFE = NI + NCC ­ FCInv ­ WCInv + net borrowing FCFE = CFO ­ FCInv + net borrowing For forecasting FCFE, use: FCFE = NI ­ [(1 ­ DR) × (FCInv ­ Dep)] ­ [(1 ­ DR) × WCInv]

Level 2

© 2008, Kaplan Schweser

Card 74 of 158

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