EXCEL PROFESSIONAL INSTITUTE 3.3 ADVANCED FINANCIAL MANAGEMENT LECTURES SLIDES FREDERICK OWUSU PREMPEH
EXCEL PROFESSIONAL INSTITUTE Lecture 9 Valuation and the use of free cash flows
The free cash flow is the cash flow derived from the operations of a company after subtracting working capital, investment and taxes and represents the funds available for distribution to the capital contributors, i.e shareholders and debtholders. Earnings before interest and tax (EBIT) Less tax on EBIT Plus non-cash charges (eg depreciation) Less capital expenditure Less net working capital increases Plus net working capital decreases Plus salvage value received xxxx (xx) xx (xx) (xx) XX XX
Free cash flows can be forecast in similar ways to such other items as expenses, sales and capital expenditure. Constant growth: One approach to forecasting free cash flows is to assume that they will grow at a constant rate.
Where free cash flow is forecasted over a number of periods where the growth rate is assumed to be constant the following formula can be used.
Differing growth rates: When the elements of free cash flow are expected to grow at different rates, each element must be forecasted separately using the appropriate rate. Free cash flow can then be estimated using the revised figures for each year.
Free cash flow to equity: This is the residual cash flow left over after meeting interest and principal payments. Direct method of calculation FCFE = Net income (EBIT Net interest Tax paid) Add depreciation Less total net investment (change in capital investment + change in working capital) Add net debt issued (new borrowings less any repayments)
Indirect method of calculation: Using the indirect method, FCFE is calculated as follows. FCF (Net Interest + Net debt paid) Add tax benefit from debt (net interest x tax rate) xxx (x) X
Market capitalisation is the market value of a company's shares multiplied by the number of issued shares. The net assets method of share valuation The value of a share in a particular class is equal to the net tangible assets divided by the number of shares. Intangible assets (including goodwill) should be excluded, unless they have a market value (for example patents and copyrights, which could be sold).
P/E ratio (earnings) method of valuation This is a common method of valuing a controlling interest in a company, where the owner can decide on dividend and retentions policy. The P/E ratio relates earnings per share to a share's value.
The earnings yield valuation method Another income-based valuation model is the earnings yield method. The dividend growth model Using the dividend growth model we have:
Valuation using free cash flows Where we assume that free cash flows remain constant (that is, with no growth) over the appropriate horizon, then the value of the organisation is the free cash flow divided by the cost of capital. Alternatively, if the free cash flows are growing at a constant rate every year, the value can be calculated using the Gordon Model (also known as the Constant Growth Model).
Terminal values: The terminal value of a project or a stream of cash flows is the value of all the cash flows occurring from period N + 1 onwards i.e. beyond the normal prediction horizon of periods 1 to N. These flows are subject to a greater degree of uncertainty, as they are beyond the horizon 1 to N where normal forecasts are acceptable. As such, simplifying assumptions need to be made for any flows occurring after period N. Terminal values and company valuation Terminal values can be used in valuing an organisation. The value of the organisation will be calculated as the sum of the discounted free cash flows plus the discounted terminal value.
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