Question

The Free Cash Flows Valuation Approach. Explain the theory behind the free cash flow valuation approach. Why are the free cash flows value relevant to common equity shareholders when they are not cash flows to those shareholders, but rather are cash flows into the firm?

Answer 1

Theory behind the free cash flow valuation approach is to find the free cash flows which are available to the company and these free cash flows will be used to dispose off debt related to debt holders and payments which are related to preference shareholders and other creditors as well and when the excess cash will be available they would be paid to equity shareholders or they would be reinvested back into the business so free cash flows will be taking all such considerations of operating expenses and it will not be including any kind of non operating expenses like interest expense and it will be used to represent the cash flows which are available to the company in the short run as well as in the long run,so these cash flows will be be helpful in determination of proper valuation of the company by investors, insiders as well as lenders.

Free cash flows are relevant to the equity share holder because these will be representing the residual cash flow which are available to the equity shareholders after payment has been made to debt holders and other preference share holder so it will be representing the residual valuation which will be used to payment of dividend for the equity shareholders or they will also be used for reinvesting into the growth of business.

they are the cash flows which are available to the firm, but they are important for the equity share holder because it will be representing that these cash flows are important as they will be indicating a higher amount of growth rate and survival as well as payment of dividend to the equity share holder.