module 4: free cash flow (fcf) - which cash flows do we...
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70391 - Finance
Module 4: Free Cash Flow (FCF)Which cash flows do we discount?
70391 – Finance – Fall 2016Tepper School of BusinessCarnegie Mellon Universityc©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?I “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 otherkind of capital.
FCF 2
What is FCF?
FCF 3
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
Market Interest Rates
Efficient Markets Market forces will tend to drive market value toward intrinsic value
Risk
Cost of Capital (%)
Investors required rate-of-return
Intrinsic Value of Operations (Discounted FCF)
Market Value of the Firm
Total Debt
Market Value of Equity
Share Price
Number of Shares
Non-Operating Assets (Cash)
Discounted by
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
Market Interest Rates
Risk
Cost of Capital (%)
Investors required rate-of-return
Intrinsic Value of Operations (Discounted FCF)
Discounted by
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?
V0 =E(c1
)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 businessoperations
:: Free Cash Flow
= Amount of after-tax cash-flow generated by the company’sbusiness operations
:: Ignore interest income (expense), dividends, etc.
:: Include some things that do not appear on the incomestatement (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
:: NOPAT
= Amount of after-tax profit generated by a firm’s businessoperations
:: Free Cash Flow
= Amount of after-tax cash-flow generated by the company’sbusiness operations
:: Ignore interest income (expense), dividends, etc.
:: Include some things that do not appear on the incomestatement (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” theeasier it is to communicate]
FCF 10
Incremental FCF
FCF 11
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
Market Interest Rates
Efficient Markets Market forces will tend to drive market value toward intrinsic value
Risk
Cost of Capital (%)
Investors required rate-of-return
Intrinsic Value of Operations (Discounted FCF)
Market Value of the Firm
Total Debt
Market Value of Equity
Share Price
Number of Shares
Non-Operating Assets (Cash)
Discounted by
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
Market Interest Rates
Risk
Cost of Capital (%)
Investors required rate-of-return
Intrinsic Value of Operations (Discounted FCF)
Discounted by
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 FlowDiscount 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?
0 1 2 3 . . . t
FCF 13
2. Focus on Incremental Free Cash FlowDiscount 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?
0 1 2 3 . . . t
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 atdelivery) Sales are about 1 per month.
:: How much could you reduce the price of the jet if thecustomer 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
:: Boeing has a jet that sells for $10 million per jet (paid atdelivery) Sales are about 1 per month.
:: How much could you reduce the price of the jet if thecustomer 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?
NOPAT down, but Invested Capital down too. Net effect depends on pre-projectROIC. 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’tmatter.
FCF 20
3. Example
:: What happens to ROIC?
NOPAT down, but Invested Capital down too. Net effect depends on pre-projectROIC. 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’tmatter. FCF 20
Monthly Granularity
FCF 21
FCF 22
FCF 23
3. ExampleWe 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 paytax 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 inplace at the start of the year to support sales in the coming year. Ifsales are expected to grow by 12% per year for the next five years,what are the incremental cash flows associated with the growth ininventory? (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.
:: AP will be 2/12 of sales
:: Note: doesn’t depend on inventory level (as % of sales).
:: Bathtub metaphor
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 peculiarreasons in the tax code it can depreciate the asset over 5 years orover 2 years (straight line). The company can choose. Does itmatter? 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 FCFin both is the same. But FCF now is better than FCF later; sodepreciate (for tax) as fast as you can.
:: Assumptions:
:: That you have taxable income. If your effective tax rate is zerosince you are currently losing money, for example, things getcomplicated (e.g., loss carryovers).
:: Tax rate is constant. If future tax rates are expected to behigher, then you might want to save the depreciationdeduction for later years.
FCF 33
Accelerated Depreciation
FCF 34
Example 3
UPMC performs a Tachyon Beam Exam bills at $15 [thousand] pertest. Demand is about 1 per month. The cost is $12 per test (thatis about a 20% margin). Insurance usually pays 12 months afterthe test How much could we reduce the price per exam forpayment 3 months after the test? UPMC is a non-profit, so thetax rate is zero. Cost of capital is 10%. Assume sales at this levelwill continue at this level indefinitely into the future (a simplifyingassumption).
FCF 35
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
:: Solve for x such that NPV =0. This is the largest price dropwe can do.
x = 13.95
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
:: Solve for x such that NPV =0. This is the largest price dropwe can do.
x = 13.95
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
:: Solve for x such that NPV =0. This is the largest price dropwe can do.
x = 13.95
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
:: Solve for x such that NPV =0. This is the largest price dropwe can do.
x = 13.95
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
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