Chapter 2

Forecasting and Valuation of Free Cash Flows

2.1 FREE CASH FLOWS

In this chapter, we study how to determine the value of a company or a business unit. By value we mean the price investors would be willing to pay in a competitive capital market. Pricing an asset is done by comparing its free cash flows to those derived from other assets of similar risk available to investors.1

Why do we find it necessary to refer to a cash flow that is “free”? In practice, the term cash flow has many uses. For example, accountants define the cash flow of a company as the sum of net income plus depreciation and other non-cash items that are subtracted in computing net income. However, that cash flow is not generally available for distribution to investors when the firm plans to reinvest all or part of it to replace equipment and finance future growth. Free cash flow is the cash available for distribution to investors after all planned capital investments and taxes.

The free cash flows generated by an enterprise can be broken down into two components: (a) the after-tax cash flows corresponding to equity-holders and (b) the after-tax cash flows available to pay debt-holders. However, the aggregate magnitude of free cash flows is independent of the debt-equity mix adopted by the firm; the latter determines only the allocation of free cash flows among classes of security-holders. In the following sections, we study how to estimate aggregate free cash flows and how to value them and their components. ...

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