Page 100 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 3: Introduction to Security Analysis

Notes

Notes Since banks have significant liabilities that are owed to the retail depositors, they
indeed have significant liabilities that are part of operations.
The “cash flow to the enterprise” approach value the equity of the firm as the value of the
operations less the value of the debt. The value of the operations is the present value of the
future free cash flows expected to be generated. The free cash flow is calculated by taking the
operating earnings (earnings excluding interest expenses), subtracting items that required cash
but that did not reduce reported earnings, and adding non-cash items that did reduce reported
earnings but that did not result in cash expenditures. Interest and dividend payments are not
subtracted since we are calculating the free cash flow available to all capital providers, both
equity and debt, before financing. The result is the cash generated by operations. The free cash
flow basically is the cash that would be available to shareholders if the firm had no debt-the cash
produced by the business regardless of the way it is financed. The expected determine the
enterprise value. The value of the equity then is the enterprise value less the value of the debt.

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Caution When valuing cash flows, proforma projections are made a certain number of
years into the future, then a terminal value is calculated for years thereafter and discounted
back to the present.

3.3 Free Cash Flow Calculation

Free cash flow (FCF) is cash flow available for distribution among all the securities holders of an
organization. They include equity holders, debt holders, preferred stock holders, convertible
security holders, and so on. The free cash flow (FCF) is calculated by starting with the profits
after taxes, then adding back depreciation that reduced earnings even though it was not a cash
outflow, then adding back after-tax interest (since we are interested in the cash flow from
operations), and adding back any non-cash decrease in net working capital (NWC).

Example: If accounts receivable decreased, this decrease had a positive effect on cash
flow.
If the accounting earnings are negative and the free cash flow is positive, the carry-forward tax
benefit is in realized in the current year and must be added to the FCF calculation.
When a company has negative sales growth it’s likely to diminish its capital spending
dramatically. Receivables, provided they are being timely collected, will also ratchet down. All
this “deceleration” will show up as additions to Free Cash Flow. However, over the longer
term, decelerating sales trends will eventually catch up.

3.4 Leverage

In 1958, economists and now Nobel Laureates Franco Modigliani and Merton H. Miller proposed
that the capital structure of a firm did not affect its value, assuming no taxes, no bankruptcy
costs, no transaction costs, that the firm’s investment decisions are independent of capital structure,
and that managers, shareholders, and bondholders have the same information. The mix of debt
and equity simply reallocates the cash flow between stockholders and bondholders but the total
amount of the flow is independent of the capital structure. According to Modigliani and Miller’s
first proposition, the value of the firm if levered equals the value unlevered:
V = V
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