Question

1. How to calculate the free cash flow of the firm (also referred to as the firm’s free cash flow) directly? How to calculate the firm’s free cash flow from earnings in a levered firm? What is the appropriate discount rate for the firm’s free cash flow if the firm plans to have a constant debt-to-equity ratio forever? What do you get when you calculate the present value of the free cash flow of the firm in this case? What is the appropriate discount rate for the firm’s free cash flow if the firm plans to have debt only for 5 years and the interest payment varies over years? What do you get when you calculate the present value of the free cash flow of the firm using this discount rate?

Describe how to estimate the free cash flow to equity in a levered firm starting from the firm’s free cash flow as we discussed in class. What is the right discount rate for the free cash flow to equity? What do you get when you calculate the present value of the free cash flow to equity? What’s the difference between the free cash flow of the firm and the free cash flow to equity?

Answer 1

1)

A) The free cash flow to the firm is the total cash flow available to the firm after paying taxex. The free cash flow can be calculated as

Non-operating profit after taxes (NOPAT) + Depreciation and amortization -capital expenditure - change in Net working capital

B) The firm free cash flow in a levered firm can be calculated in different ways, depending where is the starting point. The free cash flow to the firm for a levered firm can be calculated as:

FCFF = Net Income + Depreciation and amortization + Interest *( 1- tax rate) - capital expenditure - changes in net working capital

C) The appropriate discount rate for the free cash flow if firm plans to have a constant debt-equity ratio is to use the weighted average cost of capital. To calculate the WACC, firm will have to calculate the cost of equity and multiply with the weight of equity and calculate the after tax cost of debt and multiply with the weight of debt.

D) if we calculate the present value of all the free cash to firm occuring in the future and sum, we get the total value of the firm today. Present value helps in estimating the value of firm today.

E) If the firm plans to have the debt only for 5 years, the appropriate discount rate is to consider debt in calculating wacc for five years and then from next year onwards not use debt in the calculation of WACC.

F) Again we will get the total value of the firm today.

2)

A) calculating Free cash flow from equity from free cash flow to firm

FCFF = Free cash flow to firm

FCFE = Free cash flow to equity.

FCFE = FCFF - Interest *( 1- Tax rate ) + Net borrowings

B) The right discount rate for the free cash flow to equity is to discount it by the cost of equity.

C) When we discount the present value of equity, we get the total present value of equity today.

D) The difference between the free cash flow to firm and free cash flow to equity is that free cash flow to the firm is the cash flow occuring to the firm (inclusive of debt), while the free cash flow to equity is the cash flow occuring to that equity shareholders.