Module 4: Free Cash Flow (FCF) Which cash flows do we discount?

70391 - Finance Module 4: Free Cash Flow (FCF) Which cash flows do we discount? 70391 Finance Fall 2016 Tepper School of Business Carnegie Mellon University c 2016 Chris Telmer. Some content from slides by Bryan Routledge. Used with permission. 09.26.2016 11:12

Three Main Things :1: Which cash flows should we discount? Free Cash Flows (FCF) :2: Make decisions based on how they affect incremental FCF :: Today: valuation of incremental projects for a firm :: Next topic: valuation of firm (sum of the projects) :3: Don t forget that working capital is capital, just like any other kind of capital. FCF 2

What is FCF? FCF 3

1. Free Cash Flow (of the Business) FCF is NOT NOPAT Total Debt Share Price Number of Shares Market Value of Equity Market Value of the Firm Intrinsic Value of Operations (Discounted FCF) Non-Operating Assets (Cash) Efficient Markets Market forces will tend to drive market value toward intrinsic value Discounted by Cost of Capital (%) Investors required rate-of-return Future Free Cash Flow (FCF) Profitability and Efficiency Profit margins Operating efficiency Capital (asset) efficiency ROIC Growth Opportunities New customers New products R&D, innovation Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty Market Interest Rates Risk Capital Markets Capital Structure (firm s choice of debt and equity) FCF 4

1. Free Cash Flow (of the Business) FCF is NOT NOPAT Intrinsic Value of Operations (Discounted FCF) Discounted by Cost of Capital (%) Investors required rate-of-return Future Free Cash Flow (FCF) Profitability and Efficiency Profit margins Operating efficiency Capital (asset) efficiency ROIC Growth Opportunities New customers New products R&D, innovation Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty Market Interest Rates Risk Capital Markets Capital Structure (firm s choice of debt and equity) FCF 4

1. Free Cash Flow (of the Business) FCF is NOT NOPAT Future Free Cash Flow (FCF) Profitability and Efficiency Profit margins Operating efficiency Capital (asset) efficiency ROIC Growth Opportunities New customers New products R&D, innovation Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty FCF 4

1. Which Cash Flows? :: What is the C in DCF? V 0 = E( ) c 1 1 + r + E ( ) c2 (1 + r) 2 + E ( ) c3 (1 + r) 3 +... :: NOPAT? FCF 5

1. What is FCF? FCF 6

1. Free Cash Flow :: NOPAT = Amount of after-tax profit generated by a firm s business operations :: Free Cash Flow = Amount of after-tax cash-flow generated by the company s business operations :: Ignore interest income (expense), dividends, etc. :: Include some things that do not appear on the income statement (CAPEX, change in working capital) :: Exclude some things that do appear on the income statement (DDA) :: Cash flow available ( free ) to pay to capital providers FCF 7

1. Free Cash Flow (of the Business) FCF 8

1. Free Cash Flow (of the Business) FCF 9

1. Free Cash Flow: Template [You will see lots of variations in layout. In general, the more it looks like an income statement or cash-flow statement the easier it is to communicate] FCF 10

Incremental FCF FCF 11

2. Focus on Incremental Free Cash Flow Total Debt Share Price Number of Shares Market Value of Equity Market Value of the Firm Intrinsic Value of Operations (Discounted FCF) Non-Operating Assets (Cash) Efficient Markets Market forces will tend to drive market value toward intrinsic value Discounted by Cost of Capital (%) Investors required rate-of-return Future Free Cash Flow (FCF) Profitability and Efficiency Profit margins Operating efficiency Capital (asset) efficiency ROIC Growth Opportunities New customers New products R&D, innovation Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty Market Interest Rates Risk Capital Markets Capital Structure (firm s choice of debt and equity) FCF 12

2. Focus on Incremental Free Cash Flow Intrinsic Value of Operations (Discounted FCF) Discounted by Cost of Capital (%) Investors required rate-of-return Future Free Cash Flow (FCF) Profitability and Efficiency Profit margins Operating efficiency Capital (asset) efficiency ROIC Growth Opportunities New customers New products R&D, innovation Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty Market Interest Rates Risk Capital Markets Capital Structure (firm s choice of debt and equity) FCF 12

2. Focus on Incremental Free Cash Flow Future Free Cash Flow (FCF) Profitability and Efficiency Profit margins Operating efficiency Capital (asset) efficiency ROIC Growth Opportunities New customers New products R&D, innovation Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty FCF 12

2. Focus on Incremental Free Cash Flow Future Free Cash Flow (FCF) Growth Opportunities New customers New products R&D, innovation FCF 12

2. Focus on Incremental Free Cash Flow Discount rate = 10% Existing firm s cash flow: :: $1100 in year 1 and $1210 in year 2 (and zero after that) Firm considers project that will change cash flow to: :: $1100 in year 1 and $1331 in year 2 (and zero after that) How much does project increase PV? FCF 13

2. Not to Forget :: Focus on incremental cash-flow = What changes based on your decision :: Consider all cash-flows (and only once!) :: Remember working capital changes :: Forget sunk costs :: Include opportunity costs :: Remember to account for taxes FCF 14

Working Capital FCF 15

3. Working Capital :: Working Capital that is part of the business includes :: Inventory :: Accounts Receivable :: Accounts Payable :: Customer Pre-Payments (e.g., gift cards) ::... FCF 16

3. Example :: Boeing has a jet that sells for $10 million per jet (paid at delivery) Sales are about 1 per month. :: How much could you reduce the price of the jet if the customer agrees to pay 12 months early? Other info :: The jet program is very long term :: Tax Rate is 30% :: Opportunity cost of capital is 8.9% :: Current operating capital (invested capital) for this line of business is $250 FCF 17

3. Example FCF 18

3. Example: Using FCF Statement FCF 19

3. Example :: What happens to ROIC? FCF 20

3. Example :: What happens to ROIC? NOPAT down, but Invested Capital down too. Net effect depends on pre-project ROIC. If less than 8.4/108, ROIC goes down for all future years. If not, it goes up. Point: NPV > 0 so we should invest. Might make ROIC go down, but this doesn t matter. FCF 20

Monthly Granularity FCF 21

FCF 22

FCF 23

3. Example We deliver jets in years 1 to 5. Get paid for Year-5 jets in year 4. Deliver jets in Year-5and get no sales revenue. Note that we pay tax at delivery date, so tax savings happen in Year 5. :: What if the jet design (i.e., sales) only occur for 5 years? 0 1 2 3 4 5 FCF 24

3. Example FCF 25

Examples FCF 26

Example 1 Sales last year were $100,000. Inventory of 10% of sales must be in place at the start of the year to support sales in the coming year. If sales are expected to grow by 12% per year for the next five years, what are the incremental cash flows associated with the growth in inventory? (How big is the investment in inventory each year?) FCF 27

Answer FCF 28

Wrinkle Suppose that inventory doesn t have to be paid for 60 days. FCF 29

Wrinkle Suppose that inventory doesn t have to be paid for 60 days. :: AP will be 2/12 of sales :: Note: doesn t depend on inventory level (as % of sales). :: Bathtub metaphor FCF 29

Answer: 60-Day AP Notice: growth in sales has an extra kick (positive) to free-cash-flows. Effectively, you are selling to the customer before you have to pay your supplier FCF 30

Example 2 M Inc. purchases a new asset for $500,000. For odd and peculiar reasons in the tax code it can depreciate the asset over 5 years or over 2 years (straight line). The company can choose. Does it matter? The tax rate is 35%. Any assumptions you need to make? :: Remember: Focus on incremental cash flows. FCF 31

Answer FCF 32

Note :: Depreciation matters only via its effect on taxes. Sum of FCF in both is the same. But FCF now is better than FCF later; so depreciate (for tax) as fast as you can. :: Assumptions: :: That you have taxable income. If your effective tax rate is zero since you are currently losing money, for example, things get complicated (e.g., loss carryovers). :: Tax rate is constant. If future tax rates are expected to be higher, then you might want to save the depreciation deduction for later years. FCF 33

Accelerated Depreciation FCF 34

Example 3 UPMC performs a Tachyon Beam Exam bills at $15 [thousand] per test. Demand is about 1 per month. The cost is $12 per test (that is about a 20% margin). Insurance usually pays 12 months after the test How much could we reduce the price per exam for payment 3 months after the test? UPMC is a non-profit, so the tax rate is zero. Cost of capital is 10%. Assume sales at this level will continue at this level indefinitely into the future (a simplifying assumption). FCF 35

Answer :: Reduce price from 15 to x. Annual loss in EBIT = 12(x 15), forever, starting now. FCF 36

Answer :: Reduce price from 15 to x. Annual loss in EBIT = 12(x 15), forever, starting now. :: AR was 180. It will reduce to 3x. Change in AR is 180-3x. FCF 36

Answer :: Reduce price from 15 to x. Annual loss in EBIT = 12(x 15), forever, starting now. :: AR was 180. It will reduce to 3x. Change in AR is 180-3x. :: NPV: NPV = 180 3x + 12 ( x 15 ) + 12( x 15 ) 0.1 FCF 36

Answer FCF 37

Summary FCF 38

Valuing the FCF Which c in the numerator? The incremental free cash flow: :: Start with NOPAT :: Add back DDA (& any other non-cash expenses ) :: Subtract CAPEX :: Add the reduction in working capital (or subtract the increase) Discount the free cash flow and compute the PV :: Figure out the appropriate discount factor :: Add er up! FCF 39