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Free Cash Flows = NOPAT – Net Investment in Operating Capital

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A firm which does not pay dividends can be valued by discounting all its FREE CASH FLOWS by its WACC

Free Cash Flows = the cash flows actually available for distribution to investors after the company has made all the new products, and working capital necessary to sustain ongoing operations

- Free Cash Flows = NOPAT – Net Investment in Operating Capital

NOPAT = The Net Profit that a company would generate if it had no debt and held no non-operating assets

- NOPAT = EBIT (1-Tax Rate)

Net Investment in Operating Capital = Change in Operating Capital

Operating Capital = Net Fixed Assets + Net Operating Working Capital

Net Operating Working Capital = the working capital acquired with investor-supplied funds i.e.

Current Assets – (Accounts Payable + Accruals)

2000

1999

Cash

7,282

57,600

AR

632,160

351,200

Inventories

1,287,360

715,200

Total CA

1,926,802

1,124,000

Gross FA

1,202,950

491,000

Less: Deprec.

263,160

146,200

Net FA

939,790

344,800

Total Assets

2,866,592

1,468,800

2000

1999

Accts payable

524,160

145,600

Notes payable

720,000

200,000

Accruals

489,600

136,000

Total CL

481,600

1,733,760

Long-term debt

1,000,000

323,432

Common stock

460,000

460,000

Retained earnings

(327,168)

203,768

Total equity

132,832

663,768

Total L&E

2,866,592

1,468,800

2000

1999

Sales

5,834,400

3,432,000

COGS

5,728,000

2,864,000

Other expenses

680,000

340,000

(573,600)

228,000

EBITDA

116,960

18,900

Depr. & Amort.

EBIT

(690,560)

209,100

Interest exp.

176,000

62,500

EBT

(866,560)

146,600

Taxes (40%)

(346,624)

58,640

Net income

(519,936)

87,960

What was the free cash flow (FCF) for 2000?

FCF = NOPAT – Net investment in Operating Capital

= -$414,336 – ($1,852,832 – 1,187,200)

= -$414,336 – $665,632

= -$1,079,968.

net operating profit after taxes (NOPAT)?

NOPAT = EBIT(1 – Tax rate)

NOPAT00 = -$690,560(1 – 0.4)

= -$690,560(0.6)

= -$414,336.

Operating

capital

= Net fixed assets + NOWC

= $939,790 + $913,042

= $1,852,832.

= $1,187,200.

Operating

capital00

Operating

capital99

Issues Regarding the Free Cash Flow Method

- Free cash flow method is often preferred to the dividend growth model--particularly for the large number of companies that don’t pay a dividend, or for whom it is hard to forecast dividends.

(More...)

FCF Method Issues Continued

- Similar to the dividend growth model, the free cash flow method generally assumes that at some point in time, the growth rate in free cash flow will become constant.
- Terminal value represents the value of the firm at the point in which growth becomes constant.

FCF estimates for the next 3 years are -$5, $10, and $20 million, after which the FCF is expected to grow at 6%. The overall firm cost of capital is 10%.

0

1

2

3

4

...

k = 10%

g = 6%

-5 10 20 21.20

-4.545

8.264

15.026

21.20

0.04

530 = = *TV3

398.197

416.942

*TV3 represents the terminal value of the firm, at t = 3.

The firm’s value would therefore be

$416.942

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