Lessons in Corporate Finance, 2nd Edition

CHAPTER 21Understanding Free Cash Flows (The Dollar Stores)

The previous chapter used the technique of free-cash flows to the firm (FCF_f) to value Family Dollar. That approach used the WACC to discount the cash flows. In this chapter, we will explore more deeply how the free cash flow formulas are derived. We will do this while introducing the free cash flows to equity (FCF_e) technique. The FCF_e has several advantages over the FCF_f approach. In particular, FCF_e allows the debt ratio to vary, which is useful when evaluating LBOs and restructurings where the debt level may change dramatically over time. It can also handle subsidized interest rates and the new cap on interest deductibility in U.S. tax law. This approach is now a standard at almost all investment banks (and is usually called an LBO valuation) and is used in combination with the free-cash-flows-to-the-firm approach. The FCF_f approach still dominates in corporations, although more corporations are using both FCF_f and FCF_e.

COMPARING THE FREE-CASH-FLOWS FORMULAS

As described in Chapter 15 and 20, the formula for free cash flows to the firm is: EBIT after tax plus depreciation minus CAPEX minus the change in working capital plus any extras.

where:

• FCF_f = free cash flows to the firm
• EBIT = earnings before interest and taxes
• T_c = the average tax rate to the firm
• Dep = depreciation and amortization
• CAPEX = capital expenditures ...