Raising Entrepreneurial Capital

Tangible assets $1, 150, 000

Goodwill

472, 222

Firm value $1, 622, 222

FREE CASH FLOW VALUATION

D

EFINED

Free cash flow valuation defines the value of the firm as the present value

of the expected future cash flows in excess of those needed to operate the

company. More specifically, a firm’s economic or intrinsic value is equal to

the present value of its ‘‘free cash flows’ ’ discounted at the company’s cost of

capital, plus the value of the firm’s non-operating assets. Examples of non-

operating assets include such items as excess investments in marketable

securities and the amount by which the firm’s pension fund is overfunded.

Shareholder or equity value is calculated as firm value minus the value of

outstanding interest-bearing debt.

There are actually two methods of calculating free cash flows, the direct

and the indirect methods. In the direct method, debt service cash flows

(interest and principal payments) are subtracted in calculating operating

cash flows, and the resulting free cash flows are discounted at the company’s

cost of equity to establish the value of the equity in the business. In the

indirect method, the total firm value is estimat ed by discounting cash flows

before interest at the firm’s weighted average cost of capital. In this method

the value of the equity can be found indirectly, by subtracting the value of

debt from total firm value. We will focus on the indirect method here since

it allows for the estimation of the total firm value, while the direct method

does not.

In the indirect method a firm’s free cash flow is calculated as follows:

Depreciation, amortization, and any other non-cash expenses deducted in the

calculation of operating earnings must be added back to operating income to

derive adjusted operating income, which is operating income adjusted to a cash

basis. Note that operating income is income before interest expense is deducted.

In effect, we are calculating the earnings available to all providers of capital,

lenders, and equity holders alike.

Adjusted operating income less cash tax payments equals after-tax cash flows

from operations, sometimes called net operating profit after tax (NOPAT).

Cash tax payments equal the actual taxes paid, which will differ from the

taxes reported on the income statement. This difference results from the differ-

ences in accounting methods used for financial statement reporting and IRS

reporting.

166 Valuation—Survey of Methods

From NOPAT we subtract the investment (increase) in current assets and invest-

ments in fixed assets, net of any increase in non-interest-bearing liabilities, to arrive

at free cash flows. Non-interest-bearing liabilities are subtracted from the increase

in assets because they provide a spontaneous source of funding that helps to offset

the cost of the increase in the firm’s assets.

Operating income

þ Depreciation and amortization



Cash tax payments

¼ NOPAT

 Increase in current assets

þ Increase in non-interest-bearing current liabilities

 Increase in fixed assets

þ

Increase in non-interest-bearing long-term liabilities

¼ Free cash flow

Free cash flows are forecast over an explicit forecast period, most com-

monly 5 years. Since the business is expected to continue indefinitely, the

cash flows beyond the explicit forecast period must also be estimated. A

continuing value is calcul ated based on the cash flow forecast for the final

year of the explicit forecast and a constant, sustainable growth rate in

perpetuity. The value of the firm is the sum of the present values of the

cash flows during the explicit period and the present value of the continuing

value. An example will illustrate the process.

ILLUSTRATING THE FREE CASH FLOW MODEL

Earlier in Table 5.1 we described the valuation of the Woodridge

Corporation based on a multiple of earnings. Let us now value the firm

based on its free cash flows. To do so requires the following information

about Woodridge:

. Sales for the most recent period

. Estimated sales growth rate, both for the explicit forecast period and

beyond

. Expected operating profit margins

. Cash tax rate

. Projected ratio of extra assets (working capital, fixed assets, other long-

term assets) and non-interest-bearing liabilities to sales

. The firm’s cost of capital

Valuation—Survey of Methods 167