This document discusses free cash flow valuation and provides examples of calculating free cash flow to the firm (FCFF) and free cash flow to equity (FCFE). FCFF is the cash flow available to the company's suppliers of capital after operating expenses and capital expenditures. FCFE is the cash flow available to equity holders after operating expenses, interest, capital expenditures, and payments to debt holders. The document shows how to compute FCFF and FCFE from net income, the statement of cash flows, and between the two metrics. An example for Pitts Corporation provides its income statement, balance sheet, cash flow statement, and calculations of FCFF and FCFE.

1. Free cash flow valuation

2. Free cash flows
 Free cash flows are the cash flows available for distribution to shareholders.
 It provide an economically sound basis for valuation.

3. Free cash flow to the firm (FCFF)
 The cash flow available to the company’s suppliers of capital after all operating
expenses (including taxes) have been paid and necessary investment in working
capital and fixed capital have been made.
 FCFF is the cash flow from operations minus capital expenditures.

4. Free cash flow to equity (FCFE)
 The cash flow available to the company’s common shareholders after all operating
expenses, interest, and principal payments have been paid and necessary
investments in working capital and capital expenditure have been made.
 FCFE is the cash flow from operations minus capital expenditures minus payments
to debtholders.

5. Present value of FCFF
 Firm value = ∑ FCFF / (1 + WACC)t
 FCFF is the cash flow available to all suppliers of capital, using WACC to discount
FCFF gives the total value of all of the firm’s capital.
 Equity value = Firm value – Market value of debt

6. Present value of FCFE
 Equity value = ∑ FCFE/(1+r)t
 FCFE is the cash flow remaining for equity holders after all other claims have been
satisfied, discounting FCFE by r (the required rate of return on equity) gives the
value of the firm’s equity.

7. Single-stage (Constant growth) FCFF and
FCFE models
 Firm value = FCFF0(1+g)/WACC – g
 Equity value = FCFEo(1+g)/r – g

8. Single-stage (Constant growth) FCFF and FCFE models
 Cagiati Enterprises has FCFF of 700 million Swiss francs (CHF)and FCFE of CHF 620
million. Cagiati’s before-tax cost of debt is 5.7 percent, and its required rate of
return for equity is 11.8 percent. The company expects a target capital structure
consisting of 20 percent debt financing and 80 percent equity financing. The tax
rate is 33.33 percent and FCFF is expected to grow forever at 5.0 percent. Cagiati
Enterprises has debt outstanding with a market value of CHF 2.2 billion and has
200 million outstanding common shares.
 What is the Cagiati’s weighted average cost of capital?
 What is the value of Cagiati’s equity using the FCFF valuation approach?
 What is the value per share using this FCFF approach?

9. Computing FCFF from Net Income
FCFF= Net income available to common stockholder
Plus Net-noncash charges
Plus Interest expense (1 – tax rate)
Less Investment in fixed capital
Less Investment in working capital

10. Computing FCFF from statement of cash flows
FCFF= Cash flow from operations
Plus Interest expense (1 – T)
Less: Investment in fixed capital
The investment in working capital does not appear in above equation because
working capital is already the part of operating cash flow.

11. Computing FCFE from FCFF
 FCFE = FCFF – Interest expense (1 – t) + Net borrowing

12. Free cash flow for equity
 FCFE = NI + NCC – FC investment – WC investment + Net borrowing
 FCFE = CFO – FC investment + Net borrowing

13. FCFF to the net income
Free cash flow to firm from Net Income:
2010 2011 2012
Net income 97.52 107.28 118.00
add: Non-cash charges 45.00 49.50 54.45
add: Interest (1-t) 10.98 12.07 13.28
less: Investmet in FC - (50.00) (55.00)
less: Investment in WC (56.00) (11.60) (12.76)
Free cash flow to the firm 97.50 107.25 117.98

14. FCFF from the statement of cash flows
Computing free cash flow from the statement of cash flows:
2010 2011 2012
Cash flow from operations 86.52 145.18 159.69
add: interest (1-t) 10.98 12.07 13.28
less: Investment in FC - (50.00) (55.00)
Free cash flow to the firm 97.50 107.25 117.98

15. FCFE from FCFF
Free cash flow to equity
Computing FCFE from FCFF
2010 2011 2012
FCFF 97.50 107.25 117.98
less: Interest (1-t) (10.98) (12.07) (13.28)
add: Net borrowing 22.40 24.64 27.10
FCFE 108.92 119.82 131.79

16. Pitts Corporation
Balance sheet
2011 2012
Assets
Current assets:
Cash and equivalents 190.00 200.00
Accounts receivable 560.00 600.00
Inventory 410.00 440.00
Total current assets 1,160.00 1,240.00
Gross fixed assets 2,200.00 2,600.00
Acc. Dep. (900.00) (1,200.00)
Net fixed assets 1,300.00 1,400.00
Total assets 2,460.00 2,640.00
Liabilities and shareholder's equity
Current liabilities
Accounts payable 285.00 300.00
Notes payable 200.00 250.00
Accrued taxes and expenses 140.00 150.00
Total current liabilities 625.00 700.00
Long-term debt 865.00 890.00
Common stock 100.00 100.00
Additional paid-in capital 200.00 200.00
Retained earnings 670.00 750.00
Total shareholder's equity 970.00 1,050.00
Total liabilities and shareholder equity 2,460.00 2,640.00

17. Statement of cash flows 2012
Operating activities:
Net income 240
Adjustments
Depreciation 300
Changes in working capital
Accounts receivable (40.00)
Inventories (30.00)
Accounts payable 15.00
Accrued taxes and expenses 10.00
Cash provided by operating activities 495
Investing activities:
Purchase of fixed assets (400.00)
Cash used for investing activities (400.00)
Financing activities:
Notes payable 50.00
Long-term financing issuances 25.00
Common stock dividends (160)
Cash used for financing activities (85.00)
Net cash increase /decrease 10.00
Cash at beginning 190.00
Cash at end 200.00
Supplemental cash flow disclosures
Interest paid 100
$
Income taxes paid 160
$

18. Computing FCFF starting with net income

19. Computing FCFF starting with net income
2012
Net income 240.00
add: Non-cash charges 300.00
add: Interest (1-t) 60.00
less: Investmet in FC (400.00)
less: Investment in WC (45.00)
Free cash flow to the firm 155.00

20. Computing FCFE starting from FCFF

21. Computing FCFE starting from FCFF
2012
FCFF 155.00
less: Interest (1-t) (60.00)
add: Net borrowing 75.00
FCFE 170.00

22. Computing FCFE starting from Net Income

23. Computing FCFE starting from Net Income
Net income 240.00
add: Net noncash charges 300.00
less: Investment in fixed assets (400.00)
less: Investment in working capital (45.00)
Plus: Net borrowing 75.00
Free cash flow to equity 170.00

24. Computing FCFF starting from CFO

25. Computing FCFF starting from CFO
Operating cash flows 495.00
add: Interest expense (1-t) 60.00
less: Net investment in fixed capital (400.00)
FCFF 155.00

26. Computing FCFE from CFO

27. Computing FCFE from CFO
Operating cash flow 495.00
less: investment in fixed capital (400.00)
plus: Net borrowing 75.00
FCFE 170.00

28. Income statement 2011 2012
Total revenues 3,000
Operating cost and expenses (2,200)
EBITDA 800
Depreciation (300)
EBIT 500
Interest expense (100)
EBT 400
Taxes @ 40% (160)
Net income 240
Dividends (160)
Changes in retained earnings 80
EPS 0.48
$
DPS 0.32
$

29. Pitts Corporation
Balance sheet
2011 2012
Assets
Current assets:
Cash and equivalents 190.00 200.00
Accounts receivable 560.00 600.00
Inventory 410.00 440.00
Total current assets 1,160.00 1,240.00
Gross fixed assets 2,200.00 2,600.00
Acc. Dep. (900.00) (1,200.00)
Net fixed assets 1,300.00 1,400.00
Total assets 2,460.00 2,640.00
Liabilities and shareholder's equity
Current liabilities
Accounts payable 285.00 300.00
Notes payable 200.00 250.00
Accrued taxes and expenses 140.00 150.00
Total current liabilities 625.00 700.00
Long-term debt 865.00 890.00
Common stock 100.00 100.00
Additional paid-in capital 200.00 200.00
Retained earnings 670.00 750.00
Total shareholder's equity 970.00 1,050.00
Total liabilities and shareholder equity 2,460.00 2,640.00