Present Value Of Operating Free Cash Flows(Ofcf) And Present Value Of Free Cash Flow Toequity (Fcfe.pdf

UNIVERSITY OF ECONOMICS AND FINANCETopic: PRESENT VALUE OF OPERATING FREE CASH FLOWS OFCF and PRESENT VALUE OF FREE CASH FLOW TO EQUITY FCFE Members: Lecturer:... Calculation Operating

UNIVERSITY OF ECONOMICS AND FINANCE

Topic:

PRESENT VALUE OF OPERATING FREE CASH FLOWS (OFCF) and PRESENT VALUE OF FREE CASH FLOW TO

EQUITY (FCFE) Members:

Lecturer:

I Present Value of Operating Free Cash Flows (OFCF)

1 Definition

OFCF is the cash generated by operations, which is attributed to all providers of capital in the firm's capital structure This includes debt providers as well as equity, which reflects a company's overall cash generation capacity before deducting interest expenses related to debt and non-cash items

2 Calculation

Operating Free Cash Flows

The goal is to determine the value of the entire company and subtract the value of the company's debt obligations to arrive at the company's equity value Notably, in this valuation technique, we discount the company's operating free cash flow (FCFF) at the company's weighted average cost of capital (WACC) instead of its cost of equity The company's free operating cash flow or free cash flow is equal to:

OFCF= EBIT(1 − Tax Rate) + Depreciation Expense − Capital Expenditures

− Δ in Working Capital − Δ in Other Assets

EX: Suppose you manage a company ABC Corporation and you want to calculate OFCF for the fiscal year ending 2022 The company's financial data

and related factors for that year are as follows: EBIT (Earnings Before Interest

and Taxes): $500,000; Tax Rate: 30% (0.3); Depreciation Expense: $50,000; Capital Expenditures: $100,000; Δ in Working Capital: -$20,000 (this is an amount the company reduces from working capital); Δ in Other Assets: $10,000 (this is the amount the company increased in other assets)

Now, you can use the OFCF formula to calculate:

OFCF = EBIT(1 - Tax Rate) + Depreciation Expense - Capital Expenditures - Δ

in Working Capital Δ in Other Assets OFCF = 500,000(1 0.3) + 50,000 100,000 (20,000) 10,000 OFCF = 350,000 + 50,000 100,000 + 20,000 -10,000 OFCF = $3-10,000

So, ABC Corporation's free cash flow from operations in 2022 is $310,000, based on the information and formula provided

Total value of the company

In this model, to calculate the value of the entire company with discounted operating free cash flow before interest payments to creditors but after deducting the amount needed to maintain the company's asset base (capital expenditure) Additionally, since we are discounting the company's total operating free cash flow, it makes sense to use the company's weighted average cost of capital (WACC) as the discount rate Therefore, when estimating the value of the corporation, the debt value will be subtracted, assuming the goal is to estimate the equity value of the company The total value of the company is equal to:

where:

Vj = value of Firm j

n = number of periods assumed to be infinite

OFCFt = the firm’s operating free cash flow in Period t

WACCj = Firm j’s weighted average cost of capital

Constant Growth

Similar to the process with the DDM, it is possible to envision this as a model that requires estimates for an infinite period Alternatively, if you are dealing with a mature firm whereby its operating cash flows have reached a stage of stable growth, you can adopt the infinite period constant growth DDM model as follows:

where:

OFCF1 = the firm's operating free cash flow in Period 1

WACC = the firm's weighted average cost of capital

gOFCF = the constant infinite growth rate of operating free cash flow

Alternatively, assuming that the firm is expected to experience several different rates of growth for OFCF, these estimates can be divided into three or four stages

Similar to the dividend model, the analyst must estimate the rate of growth and the duration of growth for each of these periods of super-normal growth

3 Advantages and disadvantages

Advantages

Indicates a business's profitability: OFCF shows the amount of money a business

can generate after deducting all costs related to daily business operations This helps evaluate the profitability and sustainability of the business

Helps measure financial performance: OFCF makes comparisons between

different businesses or projects easy, allowing evaluators to make investment or project financing decisions based on cash-specific data

Demonstrates ability to pay debt: OFCF shows the level of cash a business has

available to pay debt and fulfill financial commitments This is important for investors and banks when assessing the financial stability of a business

Disadvantages

Difficult to calculate and open to different valuation methods: OFCF calculations

can be complex and require accurate assessment of many financial factors, including projections of revenue, expenses and interest rates This makes OFCF susceptible to errors in prediction or variation in these factors

Failure to demonstrate the need for investments for the future: OFCF often focuses

on current financial performance and may ignore the need for investments for the future, such as infrastructure upgrades or research and development develop Therefore, it may not fully reflect the growth potential of the business

Does not account for non-operating factors: OFCF does not include non-operating

factors such as investing in financial markets or buying and selling assets that are not options This can reduce the accuracy of a comprehensive financial assessment

of a business

4 Meaning of OFCF

Cash flow is one of the important factors in a company's business operations If cash flow is stable, the new business will continue to grow, buy back bonds and repay debt

Therefore, many investors prefer to use the OCF index to analyze the investment situation and thereby come up with an accurate business plan Optimizing revenue, costs and business operations will have a major impact on cash flow

• OCF index > 0

The business has enough money for its business operations, which can be used to reinvest in the business to expand business operations or pay dividends

• OCF index < 0

Businesses must borrow money from outside sources using financial means, which can lead to risks for businesses and investors If OCF is negative, the business is forced to sell shares or issue new shares, leading to a decrease in stock value Or businesses have to borrow capital from outside to meet business needs, thereby posing many potential risks in business, indirectly causing stock prices to decline

However, negative OCF does not always bring bad consequences for businesses.

Maybe businesses are using money to invest in machinery and expand their business to create more cash flow in the future

1 Definition

The owner's net cash flow in English is Cash Flow to Equity, abbreviation is FCFE

The owner's net cash flow is the cash flow in the period owned by the shareholders that the shareholders after taking into account capital expenditure on asset investment and principal repayment

The owner's net cash flow is a measure of the amount of money available to the shareholders of a company after all expenses, reinvestment, and debt are paid

2 Calculation

Company stock value:

In there:

Vj: Company stock value j

FCFE: owner's net cash flow

k: capital expenditures

n: the number of maturities is assumed

Note: k of FCFE (debt payment) different with WACC of OFCF (the entire capital structure of company)

Free cash flow to equity

FCFE = Net profit – Preferred stock dividend + Amortization – Change in non-cash working capital – Capital expenditure – (Debts paid - Debt newly borrowed).

or FCFE = OFCF - Capital expenditure - (Debt paid - New debt) + Depreciation.

3 Advantages and disadvantages

Advantage:

Each investor will have a different view of the future value of the business through equity valuation

Business value results are usually given at the highest purchase price for investors Based on the valuation results, it is clear which business has a higher value (when comparing the value with other businesses)

Creating favorable conditions for investors to easily develop their ideas when owning a business It can be avoided that the accounting figures are adjusted to reflect the time when the amounts are incurred

Disadvantages:

It will be difficult for businesses without a clear business strategy to apply the FCFE valuation method

The financial structure of the business can be considered quite deeply

Applicable object of the discounted free cash flow of equity method - FCFE is suitable for subjects such as: companies with high financial leverage, companies in the process of adjusting financial leverage main, …

4 Meaning of FCFE:

Based on the owner's net cash flow (FCFE), we will determine the owner's business value using the discounted cash flow method Of course, when discounting this cash flow we must use the cost of equity

 FCFE < 0

Cash flow is not available to shareholders, so the shortfall will not pay dividends

on the one hand, and on the other hand will raise more money from issuing new shares Or vice versa, if the company wants to maintain its dividend policy, it must adjust its debt policy and investment policy

 FCFE > 0

The enterprise has excess money to make to pay dividends to shareholders, and based on that to decide the appropriate level of dividend payment It is also possible that the company that maintains the current dividend policy but still has excess cash will adjust its debt policy in the direction of reducing debt, and even buying back shares

 Exercise:

Figure 3.1: Part of the balance sheet

Figure 3.2 A part of notes to the Consolidated Financial Statements

Table 3.1: Change in non-cash working capital

Figure 3.3 Partial statement of cash flows

Table 3.2: Capital expenditure of PNJ company in 2021.

Figure 3.4 Partial statement of cash flows

Table 3.3: PNJ Company outstanding debts in 2021

Figure 3.5 Partial income statement

From Table 3.1, Table 3.2, Table 3.3, Figure 3.5 we have:

Table 3.4 FCFE results of PNJ company in 2021

=> Value of the sotck of Firm:

Determining the owner's net cash flow and determining the net cash flow of the business gives us an overview of the company's life cycle, thereby making financial policy adjustments accordingly