FIN 6160 California Miramar University Free Cash Flow Questions & Responses

Description

Learning Engagement # 4
Topic:
Explain what is free cash flow as opposed to just cash flow? Why is it important to calculate fee cash flow for a company?
PROFESSOR’S GUIDANCE FOR THIS WEEK’S LE:
Not every cash produced by a business is available to its owners. You need to explain why and how? Why free cash flow is an important measure?

Topic:
Free Cash Flow and Cash Flow.
Free Cash Flow:
Free cash flow is the cash generated by a corporation from its normal business activities before interest payments and after capital expenditures are deducted. Purchases of long-term fixed assets, such as property, plant, and equipment, are referred to as capital expenditures, or CAPEX.
Free cash flow is important to investors because it shows how much actual cash a company has at its disposal. Free cash flow is the money left over after a company has met its operating and capital expenditure requirements and it can be the best way to differentiate between a good investment and a bad one (Drury, 2021).
Cash Flow:
The operating cash flow generated by normal business operations or activities, on the other hand, is referred to as cash flow. Operating cash flow indicates whether or not a company generates enough positive cash flow to run its operations and grow.
When comparing competitors in the same or similar industries, free cash flow, and operating cash flow are frequently employed as measurements. When investigating and analyzing a firm for investment, operating cash flow, free cash flow, and earnings are all crucial measures to examine (Drury, 2021).
Why is it important to calculate free cash flow for a company?
Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it’s tough to develop new products, make acquisitions, pay dividends and reduce debt. If free cash flow is negative, it could be a sign that a company is making large investments. Cash flow finds out the net cash inflow of operating, investing, and financing activities of the business. Free cash flow is used to find out the present value of the business. The main objective is to find out the actual net cash inflow of the business.
Free cash flow is typically calculated as a company’s operating cash flow before interest payments and after subtracting any capital purchases. Capital expenditures are funds a company uses to buy, upgrade, and maintain physical assets, including property, buildings, or equipment (Drury, 2021).
Operating cash flow is calculated by taking revenue and subtracting operating expenses for the period. Operating cash flow is recorded on a company’s cash flow statement, which is reported both on a quarterly and annual basis. Operating cash flow indicates whether a company can generate enough cash flow to maintain and expand operations, but it can also indicate when a company may need external financing for capital expansion.
When a company needs to service its debts, pay dividends or invest in equipment, it needs cash to do so. If a company has a large amount of excess cash, depending on the industry, it might be able to ramp up production, fuel acquisitions, or return money to shareholders. Also, companies might start booking revenue before the cash has even been paid by its customers. If customers delayed paying it could cause serious issues. The shortfall in cash caused by the company not getting paid on time or in contractual disputes meant there was an increasing shortfall of the cash needed to meet its day-to-day obligations (Stevenson, 2018).
Not every cash produced by a business is available to its owners. You need to explain why?
As a growing business, you are likely to be spending more than you have in profits because the company is investing in long-term assets to fuel its expansion. These purchases typically involve an expenditure of cash. However, the expense won’t be recognized in the same period as the cash outlay.
Cash reserves are vital to companies. The reserve holds money that a business can use when unexpected costs come up or when revenues are down. Calculating company revenue and subtracting expenses gives companies the amount per month they need to cover themselves. That’s why it’s critical to maintain a level of working capital that allows you to make it through those crunch times and continue to operate the business. Simply put, cash flow management means delaying outlays of cash as long as possible while encouraging your customers to pay it as quickly as possible (GrowthForce, 2018).
Not every cash produced by a business is available to its owners. You need to explain how?
Cash flows show the liquidity of a business. Inventory and the cost of goods sold also affect profits, but not necessarily cash because of the timing of the expenses. For example, you may have bought products to put into inventory including products you haven’t yet sold.
Cash is coming in from customers or clients who are buying your products or services. If customers don’t pay at the time of purchase, some of your cash flow is coming from collections of accounts receivable. Cash is the lifeblood of a business, and a business needs to generate enough cash from its activities so that it can meet its expenses and have enough left over to repay investors and grow the business. While a company can manipulate its earnings, its cash flow provides an idea about its real health (Thangavelu, 2021).
Why free cash flow is an important measure?
Free cash flow is an important measurement since it shows how efficient a company is at generating cash. The cash a firm generates after cash outflows to sustain operations and maintain capital assets is referred to as free cash flow (FCF). To put it another way, free cash flow is the money left over after a company’s operational and capital expenses have been paid (CapEx). Investors use free cash flow to measure whether a company might have enough cash for dividends or share buybacks.
FCF is the money left over after paying for things like payroll, rent, and taxes, and it’s up to the business to do whatever it wants with it. A company’s cash management will be aided by knowing how to calculate and analyze free cash flow. Investors will gain insight into a company’s financials as a result of the FCF calculation, which will aid them in making smarter investment decisions (Murphy, 2021).
References.
Drury, A. (2021). Free Cash Flow vs. Operating Cash Flow: What’s the Difference? Corporate Finance & Accounting. Financial Ratios. Investopedia
GrowthForce (2018). Why Profits Don’t Equal Cash Flow. GrowthForce, LLC
Murphy, C. (2021). What Is the Formula for Calculating Free Cash Flow? Corporate Finance & Accounting. Financial Ratios. Investopedia.
Stevenson, D, (2018). What Is Free Cash Flow AndWhy Is It So Important? Sharesmagazine
Thangavelu, P. (2021). Why Cash Management Is Key To Business Success. Business. Business Essentials. Investopedia

(S) A_Plus_Student:

Include

Explain what free cash flow is as opposed to just cash flow? Why is it important to calculate free cash flow for a company?
The financial performance of a corporation is measured by free cash flow (FCF). It depicts the amount of cash a firm may generate after deducting the cost of assets from its operating cash flow, such as real estate, equipment, and other significant investments. In other words, FCF assesses a company’s potential to generate what matters most to investors: cash that may be distributed at any time.

Free Cash Flow Types:
It’s not always clear what someone means when they say FCF. People could be referring to a variety of different measurements.
The following are the most prevalent types:

FCFF (Free Cash Flow to the Firm), sometimes known as “unlevered” cash flow, is a type of cash flow generated by a business.
The term “levered” refers to the ratio of free cash flow to equity.

The Importance of Cash Flow:
Management can decide on future endeavors that will increase shareholder value by knowing the company’s free cash flow. Furthermore, having a large FCF suggests that a corporation can pay its monthly obligations. FCF can also be used to grow a company’s operations or make other short-term expenditures.
As opposed to earnings per se, free cash flow is more transparent in demonstrating the company’s ability to generate cash and profits.
Investors may generally make successful investments with companies with significant FCF if they combine this with a low-valued share price. Other entities willing to invest, on the other hand, may favor companies with an excellent free cash flow and a bright future. Other investors value FCF over other metrics because it serves as a critical foundation for stock valuation.
What is the formula for calculating FCF?
There are a few different approaches to calculating FCF, but they should all yield the same answers. The following is a straightforward and widely used formula for calculating levered free cash flow:
Free Cash Flow = Operating Cash Flow (CFO) – Capital Expenditures (CFI, 2017).
The following are the distinctions between cash flow and free cash flow:

Free cash flow is a very narrow definition of cash flow. The use of free cash flow is restricted; but, the utility of cash flow is limitless.
One of the most significant four financial statements in financial accounting is the cash flow statement. The cash flow statement, on the other hand, is used to compute free cash flow.
The cash flow statement is used to determine more than just the operating cash flow. It also gives investment and financing activities the same level of attention. On the other hand, free cash flow refers to the amount of liquidity left over after a company’s asset base has been maintained or spent on.
With the use of the income statement, both cash flow and free cash flow can be determined. The indirect way of cash flow begins with Net Income, whereas the direct method starts with the company’s Sales. EBIT (Earnings before interest and taxes) is used to calculate free cash flow.
Free cash flow cannot be computed without knowing the changes in working capital. Only CAPEX and depreciation will be taken into consideration if the working capital does not change. If the cash flow from operating activities is estimated using the direct method, it is not necessary to know the changes in working capital.
The cash flow statement is a time-consuming and challenging task. On the other hand, free cash flow is simple to calculate (Khot & Vaidya, 2017).

References:
CFI. (n.d.). Risk – Definition, Types, Adjusment and Measurement. Corporate Finance Institute. Retrieved November 10, 2021, from https://corporatefinanceinstitute.com/resources/kn…
Khot, H., & Vaidya, D. (2017, September 21). Cash Flow vs Free Cash Flow. WallStreetMojo. https://www.wallstreetmojo.com/cash-flow-vs-free

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Pts Cnt
14
Critical Thinking
Responding to Others’ Thoughts
Rich in Content, Full of Thoughts
Insightful Analyis, Substantial Info
Level 3
Pts Cnt
10
4
Level 4
Pts
Cnt
6
3
0
2
X
X
X
X
X
X
X
X
X
X
X
0
Word Counts, Minimum:
DBA:
500 – 700 Words
MBA:
300 – 400 Words
BSBA, ASBA: 100 – 200 Words
Rudimentary & Superficial
No Insightful Analysis
Less Than Minimum Words
X
X
X
Connecting to …
Previous Knowledge
Currently Discussed Knowledge
Class Related Topics
Referencing Real Life Scenario(s)
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4
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by Thursday
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All missing
4
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1st Responses Rich in Content
2nd Response Rich in Content
3rd Response Rich in Content
Active Participation in class
3
Severe
Severe
Severe
2
0
X
X
X
X
X
1
X
Severe
X
0
Later
Than
Friday
1
X
X
3
1
0
X
X
X
X
X
8
8
8
X
6
6
6
2
6
6
4
6
6
2
–
Severe
4
4
0
4
4
2
–
X
Later
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DBA: 300 – 500 Words
MBA:
200 – 300 Words
BSBA, ASBA: 100 – 200 Words
Not as Rich in Content
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Total Possible Points
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X
X
X
X
X
X
X
X
X
30
22
X
Than
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14
0
Points depending on submission on or before Sunday !!
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Matrix by Dr. Georg Schlueter, Corrected to match Faculty Handbook
V.5.0, July 23, 2020
1
CHAPTER 7
Basic Stock Valuation
© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
Topics in Chapter
?
?
Features of common stock
Valuing common stock
?
?
?
?
Dividend growth model
Free cash flow valuation model
Market multiples
Preferred stock
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2
Corporate Valuation and Stock Valuation
FCF1
Value of
=
Operations
1 + WACC
FCF2
+
1
1 + WACC
FCF?
+ ?+
2
1 + WACC
?
Firm’s debt/equity mix
Free cash flow
(FCF)
Weighted average
cost of capital
(WACC)
Dividends (D)
Cost of equity: The required
return on stock
D1
Value of
=
Stock
1 + rs
+
1
D2
1 + rs
+ ?+
2
Cost of debt
D?
1 + rs
?
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Common Stock: Owners,
Directors, and Managers
?
?
?
?
?
Represents ownership.
Ownership implies control.
Stockholders elect directors.
Directors hire management.
Since managers are “agents” of
shareholders, their goal should be:
Maximize stock price.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4
Classified Stock
?
?
?
Classified stock has special provisions.
Could classify existing stock as
founders’ shares, with voting rights but
dividend restrictions.
New shares might be called “Class A”
shares, with voting restrictions but full
dividend rights.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
5
Tracking Stock
?
The dividends of tracking stock are tied to a
particular division, rather than the company
as a whole.
?
?
?
Investors can separately value the divisions.
Its easier to compensate division managers with
the tracking stock.
But tracking stock usually has no voting
rights, and the financial disclosure for the
division is not as regulated as for the
company.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
6
Different Approaches for
Valuing Common Stock
?
Free cash flow model
?
?
?
Dividend growth model
?
?
?
Constant growth
Nonconstant growth
Constant growth
Nonconstant growth
Using the multiples of comparable firms
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
7
The Free Cash Flow Valuation
Model: FCF and WACC
?
Free cash flow (FCF) is:
?
?
?
The cash flow available for distribution to
all of a company’s investors.
Generated by a company’s operations.
The weighted average cost of capital
(WACC) is:
?
The overall rate of return required by all
of the company’s investors.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
8
Value of Operations (Vop)
?
The PV of expected future FCF,
discounted at the WACC, is the value of
a company’s operations (Vop):
?
Vop =
?
t=1
FCFt
(1 + WACC)t
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
9
Sources of Value
?
?
Value of operations
Nonoperating assets
?
?
?
Short-term investments and other
marketable securities
Ownership of non-controlling interest in
another company
Value of nonoperating assets usually is
very close to figure that is reported on
balance sheets.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
10
Claims on Corporate Value
?
?
?
Debtholders have first claim.
Preferred stockholders have the next
claim.
Any remaining value belongs to
stockholders.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
11
Total Corporate Value:
Sources and Claims
Equity
Value of Operations
Mkt.
Sec.
Debt
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Pref.
Stk.
12
Value of operations= PV of
FCF discounted at WACC
Vop
FCF1
FCF2
=
+
1
(1 + WACC)
(1 + WACC)2
FCF3
FCF?
+
+?+
3
(1 + WACC)
(1 + WACC)?
?
Conceptually correct, but how do you find the
present value of an infinite stream?
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
13
Suppose FCFs are expected to grow at a
constant rate, gL, starting at t=1, and
continue forever. What happens to FCF?
FCF2 = FCF1(1 + gL)1
FCF3 = FCF1(1 + gL)2
FCFt = FCF1(1 + gL)t-1
What is the value of operations if FCFs
grow at a constant rate? See next slide.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14
Value of operations in terms
of FCF1 and gL:
Vop =
FCF1
(1+WACC)1
+
FCF1 (1+gL )1
+
2
(1+WACC)
FCF1 (1 + g L )2
FCF1 (1 + g L )t?1
+?
+?
3
t
(1 + WACC)
(1 + WACC)
?
We can multiply and divide by (1+gL), for a
reason that will soon be clear, as shown on the
next slide.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
15
Rewritten value of operations:
Vop
FCF1 (1 + g L )
FCF1 (1 + g L )1 1 + g L
=
+
1
1 + WACC 1 + g L
(1 + WACC)2 1 + g L
FCF1 (1 + g L )2 1 + g L
FCF1 1 + g L t?1 1 + g L
+
+ ?+
+?
3
t
(1 + WACC) 1 + g L
1 + WACC 1 + g L
?
We can group
FCF1
(1+gL
, as shown on the next slide.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
16
Value of operations with
grouped terms:
Vop
FCF1 FCF1 (1 + g L )1
FCF1 FCF2 (1 + g L )2
=
+
1
(1 + g L ) (1 + WACC)
(1 + g L ) (1 + WACC)2
FCF1 FCF1 (1 + g L )3
FCF1 FCF1 (1 + g L )t
+
+ ?+
+?
3
t
(1 + g L ) (1 + WACC)
(1 + g L ) (1 + WACC)
?
We can group the
the next slide.
(1+gL )
(1+WACC)
terms, as shown on
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
17
Value of operations if FCF
grows at a constant rate:
Vop
FCF1
1 + gL
=
1 + g L 1 + WACC
FCF1
+
1 + gL
?
1
FCF1
+
1 + gL
1 + gL 3
FCF1
…+
1 + WACC
1 + gL
What happens to
1+gL t
1+WACC
1 + gL
1 + WACC
2
1 + gL t
…+
1 + WACC
if t gets large? It
depends on the size of gL relative to WACC. See
next slide.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
18
What happens to
large?
?
If gL < WACC: Then ? If gL ? WACC: Then ? 1+gL t 1+WACC as t gets 1+gL t 1+WACC t 1+g L 1+WACC < 1. ? 1. What happens to the value of operations if gL ? WACC? See next slide. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 19 What happens to the value of operations if gL ? WACC? Vop FCF1 = 1 + gL FCF1 + 1 + gL ? Vop = Bigger than 1 Bigger than 1 FCF1 1+gL (Big) + Bigger) + …+ FCF1 1+gL 1 FCF1 + Bigger than 1 1 + gL 2 FCF1 Bigger than 1 1 + gL ? 3+?+ FCF1 1+gL (Bigger) + FCF1 1+gL (Even (Really big!) = Infinity! So g can’t be greater than or equal to WACC! © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20 What happens to the value of operations if gL ? WACC? FCF1 Vop = Less than 1 1 + 1 + gL FCF1 + Less than 1 3 + ? + 1 + gL ? ? Vop = FCF1 1+gL (Small) + FCF1 1+gL FCF1 Less than 1 2 1 + gL FCF1 Less than 1 ? 1 + gL (Smaller) + FCF1 1+gL (Even smaller) + …+ FCF0 (Really small!) = ? All the terms get smaller and smaller, but what happens to the sum? See next slide. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 21 What is the sum of an infinite number of factors that get smaller at a geometric rate? Consider this example. The first row is t. The second row is a number that is less than 1 that is compounded to the power of t. The third row is the cumulative sum. t 1 (1/2)t 1/2 ?(1/2)t 1/2 2 1/4 3/4 3 1/8 7/8 4 1/16 15/16 ...? 1/? ? 0 ?1 This sum converges to 1. Similarly, Vop converges (although not to 1). See next slide. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22 Constant Growth Formula for Value of Operations: gL begins at Time 1 ? If FCF are expected to grow at a constant rate of gL from Time 1 and afterwards, and gL 8.26% The higher ROIC causes an increase in Vop,0. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 54 Impact of Simultaneous Improvements in OP and CR g0,1 g1,2 g2,3 g3,4 gL OP CR ROIC Vop,0 WACC No Improve OP ? Change and CR 10% 10% 8% 8% 5% 5% 5% 5% 5% 5% 4.5% 5.5% 56.0% 51.0% 8.0% 10.8% $958 $1,756 9.00% 9.00% The ROIC is much higher due to the improvements in operations. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 55 Impact of Simultaneous Improvements in Growth, OP, and CR g0,1 g1,2 g2,3 g3,4 gL OP CR ROIC Vop,0 WACC No ? Change Improve All 10% 11% 8% 9% 5% 6% 5% 6% ? 5% 6% 4.5% 5.5% 56.0% 51.0% 8.0% 10.8% $958 $2,008 9.00% 9.00% The ROIC is much higher due to the improvements in operations. With a higher ROIC, growth adds substantial value. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 56 Summary: Value of operations for previous combinations of ROIC and gL ROIC gL ? ? ? 5% 6% 8.0% 8.8% 9.8% 10.8% $958 $1,191 $1,523 $1,756 $933 $1,247 $1,694 $2,008 When ROIC is low (8%), increasing growth reduces value. When growth is low (5%), increasing ROIC adds value. When ROIC is high enough, increasing growth adds enormous value. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 57 Are volatile stock prices consistent with rational pricing? ? ? ? ? The previous slide shows that small changes in ROIC and growth cause large changes in value. Similarly, small changes in the cost of capital (WACC), perhaps due to changes in risk or interest rates, cause large changes in value. As new information arrives, investors continually update their estimates of operating profitability, capital requirements, growth, risk, and interest rates. If stock prices aren’t volatile, then this means there isn’t a good flow of information. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 58 Value of dividend-paying stock = PV of dividends discounted at required return ^ P0 = D1 (1 + rs)1 + D2 (1 + rs)2 + D3 +…+ (1 + rs)3 D? (1 + rs)? Conceptually correct, but how do you find the present value of an infinite stream? © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 59 Suppose dividends are expected to grow at a constant rate, gL, forever. D1 = D0(1 + gL)1 D2 = D0(1 + gL)2 Dt = D0(1 + gL)t What is the present value of a constant growth Dt when discounted at the stock’s required return, rs? See next slide. © 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 60 Present Value of a Constant Growth Dividend ? ? PV = Dt 1+rs t = D0 1+gL t 1+rs t What happens to bigger? 1+gL t 1+rs 1+gL t 1+rs = 1+gL t D0 1+rs as t gets ? If gL rs, then + (1 + rs)2 (1 + gL)t (1 + rs)t +…+ > 1, and
D0(1 + gL)?
(1 + rs)?
^
P0 = ?
So gL must be less than rs for the constant
growth model to be applicable!!
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Constant Dividend Growth Model (gL
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financial statement

managerial Finance

free cash flow

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