FIRST FINANCIAL MODEL

account the way the business is fi nanced—is the best measure of the cash produced by a business.⁵ The easiest way to defi ne the free cash fl ow is as follows:

Defi ning the Free Cash Flow Profi t after

taxes

This is the basic measure of the profi tability of the business, but it is an accounting measure that includes fi nancing fl ows (such as interest), as well as noncash expenses such as depreciation. Profi t after taxes does not account for either changes in the fi rm’s working capital or purchases of new fi xed assets, both of which can be important cash drains on the fi rm.

+Depreciation This noncash expense is added back to the profi t after tax.

+After-tax interest payments (net)

FCF is an attempt to measure the cash produced by the business activity of the fi rm. To neutralize the effect of interest payments on the fi rm’s profi ts, we

• Add back the after-tax cost of interest on debt (after-tax since interest payments are tax deductible).

• Subtract out the after-tax interest payments on cash and marketable securities.

−Increase in current assets

When the fi rm’s sales increase, more investment is needed in inventories, accounts receivable, etc. This increase in current assets is not an expense for tax purposes (and is therefore ignored in the profi t after taxes), but it is a cash drain on the company.

+Increase in current liabilities

An increase in the sales often causes an increase in fi nancing related to sales (such as accounts payable or taxes payable). This increase in current liabilities—when related to sales—provides cash to the fi rm.

Since it is directly related to sales, we include this cash in the free cash fl ow calculations.

−Increase in fi xed assets at cost

An increase in fi xed assets (the long-term productive assets of the company) is a use of cash, which reduces the fi rm’s free cash fl ow.

Here is the calculation for our fi rm:

5. Extensive discussions of free cash fl ow and its uses in a valuation context can be found in books by Benninga and Sarig (1997) and by McKinsey & Company, Inc., et al.

(2005).

Free cash flow calculation

Profit after tax 246 270 295 323 352

Add back depreciation 117 137 161 189 220

Subtract increase in current assets (15) (17) (18) (20) (22)

Add back increase in current liabilities 8 9 10 11 12

Subtract increase in fixed assets at cost (194) (222) (254) (291) (333)

Add back after-tax interest on debt 19 19 19 19 19

Subtract after-tax interest on cash and mkt. securities (5) (9) (12) (16) (20)

Free cash flow 176 188 201 214 228

G

53

Cash flow from operating activities

Profit after tax 246 270 295 323 352 <-- =G22 Add back depreciation 117 137 161 189 220 <-- =-G19 Adjust for changes in net working capital:

Subtract increase in current assets (15) (17) (18) (20) (22)<-- =-(G28-F28) Add back increase in current liabilities 8 9 10 11 12 <-- =G35-F35 Net cash from operating activities 356 400 448 502 562 <-- =SUM(G55:G59)

Cash flow from investing activities

Aquisitions of fixed assets--capital expenditures (194) (222) (254) (291) (333) <-- =-(G30-F30)

Purchases of investment securities 0 0 0 0 0 <-- Not in our model

Proceeds from sales of investment securities 0 0 0 0 0 <-- Not in our model

Net cash used in investing activities (194) (222) (254) (291) (333) <-- =SUM(G63:G65)

Cash flow from financing activities

Net proceeds from borrowing activities 0 0 0 0 0 <-- =G36-F36

Net proceeds from stock issues, repurchases 0 0 0 0 0 <-- =G37-F37

Dividends paid (98) (108) (118) (129) (141) <-- =G23

Net cash from financing activities (98) (108) (118) (129) (141) <-- =SUM(G69:G71)

Net increase in cash and cash equivalents 64 70 76 82 88 <-- =G72+G66+G60

Check: changes in cash and mkt. securities 64 70 76 82 88 <-- =G27-F27 CONSOLIDATED STATEMENT OF CASH FLOWS: RECONCILING THE CASH BALANCES

3.3.1 Reconciling the Cash Balances

The free cash fl ow calculation is different from the “consolidated state-ment of cash fl ows” that is a part of every accounting statestate-ment. The purpose of the consolidated statement of cash fl ows is to explain the increase in the cash accounts in the balance sheet as a function of the cash fl ows from the fi rm’s operating, investing, and fi nancing activi-ties. In the pro forma example of this section we treat the cash and mar-ketable securities as the balance-sheet plug; however, it can also be derived from a standard accounting statement of cash fl ows.

Line 75 checks that the changes in the cash accounts derived through the consolidated statement of cash fl ows match those derived in the fi nancial model (which uses cash as a plug). As you can see, the model works, in the sense that changes in cash balances from the consolidated statement of cash fl ows in fact match those in the projected balance sheets of the pro forma model.

3.4 Using the Free Cash Flow to Value the Firm and Its Equity

The enterprise value of the fi rm is the present value of the fi rm’s future anticipated free cash fl ows. We can use the pro forma FCF projections and a cost of capital to determine the enterprise value of the fi rm.

Suppose we have determined that the fi rm’s weighted average cost of capital (WACC) is 20 percent (recall that the calculation of the WACC

was discussed in Chapter 2). Then the enterprise value of the fi rm is the discounted value of the fi rm’s projected FCFs plus its terminal value:

Enterprise value=

= +