Page 160 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 5: Equity Valuation Models

Notes
D 2 D 1 3.00 2.00
g = 50%
2 D 1 0.75
The values V + V can be calculated as follows:
T(1) T(2)
2.0 3.0
V = t 2 4.01
T(1) (1 15) (1 15)

3.30 49.91
V = t 2
T(1) (.15 .10) (1 .15)
Since V = V + V the two values can be summed to find the intrinsic value of a Cromecon
0 T(1) T(2)
equity share time 'zero'.
This is given below:
V = 4.01 + 49.91 = 53.92
0
At the current price of 54.00, the share is fairly priced and hence you won't trade.
5.3 Free Cash Flow Models

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.

Free Cash Flows to Equity

To estimate how much cash a firm can afford to return to its stockholders, we begin with the net
income – the accounting measure of the stockholders' earnings during the period – and convert
it to a cash flow by subtracting out a firm's reinvestment needs.
First, any capital expenditures, defined broadly to include acquisitions, are subtracted from the
net income, since they represent cash outflows. Depreciation and amortization, on the other
hand, are added back in because they are non-cash charges. The difference between capital
expenditures and depreciation is referred to as net capital expenditures and is usually a function
of the growth characteristics of the firm. High-growth firms tend to have high net capital
expenditures relative to earnings, whereas low-growth firms may have low, and sometimes
even negative, net capital expenditures.
Second, increases in working capital drain a firm's cash flows, while decreases in working
capital increase the cash flows available to equity investors. Firms that are growing fast, in
industries with high working capital requirements (retailing, for instance), Typically have large
increases in working capital. Since we are interested in the cash flow effects, we consider only
changes in non-cash working capital in this analysis.
Finally, equity investors also have to consider the effect of changes in the levels of debt on their
cash flows. Repaying the principal on existing debt represents a cash outflow; but the debt
repayment may be fully or partially financed by the issue of new debt, which is a cash inflow.
Again, netting the repayment of old debt against the new debt issues provides a measure of the
cash flow effects of changes in debt.
Allowing for the cash flow effects of net capital expenditures, changes in working capital and net
changes in debt on equity investors, we can define the cash flows left over after these changes as
the free cash flow to equity (FCFE).

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