Why should I choose AnalystNotes?

Simply put: AnalystNotes offers the best value and the best product available to help you pass your exams.

Subject 4. Other issues with free cash flow analysis PDF Download
Recognition of Value

  • FCF models reflect control perspective.
  • DDMs reflect minority interest perspective.
  • Difference is function of control premium.
  • Both rely heavily on terminal value for determination of current value.

If all inputs were known and mutually consistent, a DDM and FCFE model would result in identical valuations for a stock. However, depending on the decisions of a company's board of directors, dividends may be equal to, below or above the FCFE. When the difference between actual cash flows to shareholders (dividends) and cash flow available for shareholders (FCFE) is significant, dividends are not a fair basis for value recognition. In this sense, FCFE model is preferable to DDM model, because it is not affected by discretionary dividend policy of the board.

Effect of Financing Decisions

  • Dividends, share repurchases and share issues have no effect on FCFF and FCFE.

    This is because these transactions are uses of free cash flows, but FCFF and FCFE are the cash flows available to investors or shareholders. When calculating FCFF and FCFE we only consider how these cash flows are generated, and not how they are used. Transactions between the company and its shareholders (through dividends, share repurchases, and share issuances) do not affect free cash flow.

  • Changes in leverage have only a minor effect on FCFE and no effect on FCFF.

    Changes in leverage have both short-term and long-term effect on FCFE. In the year of change, net borrowing increases FCFE. In the long-run, assuming more debt means higher interest payments, partly compensated by an increase in interest tax shield. Therefore, the long-run effect of higher leverage is the decrease in FCFE.

NI is a Poor Proxy for FCFE

  • NI includes noncash charges like depreciation. These charges should be added back to arrive at FCFE.
  • NI ignores investments in working capital and fixed assets. They should be subtracted to arrive at FCFE.
  • NI ignores net borrowing which is a part of cash flow available to shareholders, but not a part of NI.
  • EBITDA is a Poor Proxy for FCFF

  • EBITDA is a before-tax measure and doesn't reflect taxes paid. The discount rate applied to EBITDA would need to be a before-tax rate. The WACC used to discount FCFF is an after-tax rate.
  • EBITDA is a measure of operating activities only. It ignores investments a company makes in working capital and fixed assets.
  • Depreciation tax shield (the depreciation charge times the tax rate) is ignored by EBITDA.
  • For the reasons outlined above, net income and EBITDA cannot be used as proxies for free cash flows in valuation models.

    User Contributed Comments 0

    You need to log in first to add your comment.
    Thanks again for your wonderful site ... it definitely made the difference.
    Craig Baugh

    Craig Baugh

    My Own Flashcard

    No flashcard found. Add a private flashcard for the subject.