Question

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

a)Firm's Free cash flow(FCFF)

FCFF also referred as unlevered free cash flow.FCFF is the cash flow available to all funding providers.To arrive at FCFF,you can use the following formula:

i)FCFF=NOPAT+D&A-CAPEX-Change in net working capital

Where,

NOPAT=Net operating profit after tax or Net Income

D&A=Depreciation and Amortization

CAPEX=Capital Expenditure

Change in net working capital(Net increase in working capital shall be reduced and decrease in working capital shall be added back)

You can also find the FCFF by applying following formula,

FCFF=Cash flow from operation+Interest Expense(1-Tax rate)-Capital expenditure

b)Firm’s free cash flow from earnings in a levered firm(FCFE)

FCFE is the amount of cash business generates that is available to be potentially distributed to shareholders.The difference between FCFE and FCFF is that FCFF excludes the impact of interest apyments and net increase or decrease in debt,while these item are taken into consideration for FCFE.Formula for calculating FCFE is;

FCFE=Net Income+Depreciation&Amortization-Capital expenditure-Change in working capital-Debt repayment+new debt issued

c)Discount rate is the cost of financing the projects at the firm.The Weighted average cost of capital(WACC) is used as the discount.WACC is the firm's cost of capital in which each category of capital is proportionately weighted.Thus in case the firm plans to have a constant debt-to-equity ratio forever,WACC can be used as the discount rate.

d)Present value of free cash flow represent the value of firm.Thus if you discount the free cash flow using the appropriate discount rate,you will get the value of firm.