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?

Please i need a new answer.

Answer 1

Free cash flow to the firm is obtained as: Operating cash flow-Capital expenditure-Change in NWC.

It measures the balance left from the cash flow generated from operations, after spending for capital expenditure and for net working capital. That surplus is what would be available to the debt holders and the stockholders for their returns and return of capital.

Since FCFF is for all the investors [creditors and stockholders], the FCFF is discounted by the weighted average cost of capital to get the present worth of the operations of the firm.

From the present worth of operations, the market values of debt and preference are deducted to get what is due to the common stockholders; that is to get the value of the common equity. The value of common equity divided by the number of shares of common equity outstanding will give the value of the common share.

The FCFF, rather than FCFE [free cash flow to equity], is used as it gives the amount that can be generated from the assets without considering the payments on account of debt financing. It can help the analysis using different capital structures.