Residual Income Paid To Bondholders

or (3) the analyst takes a corporate control perspective. Make sure you see the parallels between the free cash flow framework and the discounted dividend framework (i.e., the basic free cash flow model is analogous to the Gordon growth model). Memorize the formulas for FCFF and FCFE. This is a very popular test topic at Level 2, as many analysts prefer free cash flow models to dividend discount models.

Free Cash Flow Valuation

LOS 42.a: Define and interpret free cash flow to the firm (FCFF) and free cash flow to equity (FCFE).

Forget about all the complicated financial statement relationships for a minute and simply picture the firm as a cash "processor." Cash flows into the firm in the form of revenues as it sells its product, and cash flows out as it pays its cash operating expenses (e.g., salaries and taxes, but not interest expense, which is a financing and not an operating expense). The firm takes the cash that's left over and makes short-term net investments in working capital (e.g., inventory and receivables) and long-term investments in property, plant, and equipment. The cash that remains is available to pay out to the firm's investors: bondholders and common shareholders (let's assume for the moment that the firm has not issued preferred stock). That pile of remaining cash is called free cash flow to the firm (FCFF) because it's "free" to pay out to the firm's investors (see Figure I). The formal definition of FCFF is the cash available to all of the firms investors, including stockholders and bondholders, after the firm buys and sells products, provides services, pays its cash operating expenses, and makes short- and long-term investments.

Professor's Note: Taxes paid are included in the definition of cash operating expenses for purposes of defining free cash flow, even though taxes aren't generally considered a part of operating income.

What does the firm do with its FCFF? First, it takes care of its bondholders because common shareholders are last in line at the money store. So it makes interest payments to bondholders and borrows more money from them or pays some of it back. However, making interest payments to bondholders has one advantage for common shareholders: it reduces the tax bill.

The amount that's left after the firm has met all its obligations to its other investors is called free cash flow to equity (FCFE), as can be seen in Figure 1. However, the board of directors srill has discretion over what to do with that money. It could pay it all our in dividends to its common shareholders, but it might decide to only pay out some of it and put the rest in the bank to save for next year. That way, if FCFE is low the next year, it won't have to cut rhe dividend payment. So FCFE is the cash available to common shareholders after funding capital requirements, working capital needs, and debt financing requirements.

Professor's Note. You need to know these general definitions! We will explore how these two cash flow measures are estimated using accounting data, and in the ^ process we'll throw a lot of formulas at you. It's much easier to remember these formulas and repeat them on the exam if you have a conceptual understanding of what FCFF and FCFE represent. That way if for example, you happen to forget the FCFE formula in the heat of the moment on exam day, you still have a chance to reconstruct it by thinking through what FCFE really is.

Figure I: FCFF and FCFE

Cash Revenues

Cash Revenues

Fixed Capital Investment

Working Capital Investment

Interest Payments to Bondholders

Net Borrowings from Bondholaers

Cash Operating Expenses

(including taxes but excluding interest expense)

Fixed Capital Investment

Interest Payments to Bondholders

Net Borrowings from Bondholaers

Working Capital Investment

Cash Operating Expenses

(including taxes but excluding interest expense)

LOS 42.b: Describe, compare, and contrast the FCFF and FCFE approaches to valuation.

LOS 42.n: Describe the characteristics of companies for which the FCFF model is preferred to the FCFE model.

We're going to use the typical discounted cash flow technique for free cash flow valuation, in which we estimate value today by discounting expected future cash flows at the appropriate required return. What makes this complicated is that we'll end up with two values we want to estimate (firm value and equity value), rwo cash flow definitions (FCFF and FCFE), and two required returns [weighted average cost of capital (WACC) and required return on equity). The key to nailing this question on the exam is knowing which cash flows to discount at which rate to estimate which value.

The value of the firm is the present value of the expected future FCFF discounted at the WACC (this is so important we're going to repeat it as a formula):

firm value = FCFF discounted at the WACC

The weighted average cosr of capital is the required return on the firm's assets. It's a weighted average of the required return on common equity and the after-tax required return on debt. We'll show you the formula later in this topic review.

Professor's Note: Technically, what we've called firm value is actually the value of the operating assets (the assets that generate cash flow). Significant nonoperating assets, such as excess cash (not total cash on the balance sheet), excess marketable securities, or land held for investment should be added to this estimate to calculate total firm value. Most of the time the value of these assets is small in relation to the present value of the FCFFs, so we don't lose much by ignoring it. If you are asked to calculate the value of the firm using the FCFF approach, calculate the present value of the FCFFs and then look for any additional information in the problem that specifically says "excess cash and marketable securities" or "land held for investment. "

The value of the firm's equity is the present value of the expected future FCFE discounted at the required return on equity:

equity value = FCFE discounted at the required return on equity

Given the value of the firm, we can also calculate equity value by simply subtracting out the market value of the debt:

equity value = firm value - market value of debt

We'll get to the details of the calculations later in this topic review. However, this is an extremely important concept, so memorize it now.

Professor's Note: A very common mistake is to use the wrong discount rate or the wrong cash flow definition. Remember, always discount FCFF at the WACC to find firm value and FCFE at the required return on equity to estimate equity value!

The differences between FCFF and FCFE account for differences in capital structure and consequently reflect the perspectives of different capital suppliers. FCFE is easier and more straightforward to use in cases where the company's capital structure is not particularly volatile. On the other hand, if a company has negative FCFE and significant debt outstanding, FCFF is generally che best choice. We can always estimate equity value indirectly by discounting FCFF to find firm value and then subtracting out the market value of debt to arrive at equity value.

LOS 42.c: Contrast the ownership perspective implicit in the FCFE approach to the ownership perspective implicit in the dividend discount approach.

LOS 42.g: Contrast the recognition of value in the FCFE model with the recognition of value in dividend discount models.

The ownership perspective in the free cash flow approach is that of an acquirer who can change the firm's dividend policy, which is a control perspective, or for minority shareholders of a company that is "in-play" (i.e., it is a takeover target with potential bidders). The ownership perspective implicit in the dividend discount approach is that of a minority owner who has no direct control over the firm's dividend policy. If investors are willing to pay a premium for control of the firm, there may be a difference between the values of the same firm derived using the two models.

Analysts often prefer to use free cash flow rather than dividend-based valuation for the following reasons:

• Dividends are paid at the discretion of the board of directors. It may, consequently, poorly reflect the firm's long-run profitability.

• If a company is viewed as an acquisition target, free cash flow is a more appropriate measure because the new owners will have discretion over its distribution.

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