Subject 4. Other issues with free cash flow analysis PDF Download
Recognition of Value
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 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.
- 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.
- Changes in leverage have only a minor effect on FCFE and no effect on FCFF.
NI is a Poor Proxy for FCFE
EBITDA is a Poor Proxy for FCFF
For the reasons outlined above, net income and EBITDA cannot be used as proxies for free cash flows in valuation models.
Learning Outcome Statementscompare the FCFE model and dividend discount models;
explain how dividends, share repurchases, share issues, and changes in leverage may affect future FCFF and FCFE;
evaluate the use of net income and EBITDA as proxies for cash flow in valuation;
CFA® 2023 Level II Curriculum, Volume 4, Module 24
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