FCF question and Beta question

you use cap-struct indifferent [unlevered] FCF's thus, you always start with NOPAT... don't know where you learned that other way, unless you invented it yourself. The other [proper] way to do it is CFO + tax-affected interest - capex, which is probably used more often since these are the metrics most broker reports give.

you need to take the levered beta in its current state (what Yahoo finance would give you) and adjust it for post-transaction cap-struct. thus, you always unlever to industry level than relever to pf cap-struct.

Didn't invent it...

http://www.investopedia.com/terms/f/freecashflow.asp

and EBIT(1-T) is the way they explain it in vault (which I know everyone thinks is garbarge, but for those of us not in banking yet, its one resource to use).

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NOPAT = EBIT (1-T)

In order to do a DCF analysis, first we need to project free cash flow for a period of time (say, five years). Free cash flow equals EBIT less taxes plus D&A less capital expenditures less the change in working capital. Note that this measure of free cash flow is unlevered or debt-free. This is because it does not include interest and so is independent of debt and capital structure.

Next we need a way to predict the value of the company/assets for the years beyond the projection period (5 years). This is known as the Terminal Value. We can use one of two methods for calculating terminal value, either the Gordon Growth (also called Perpetuity Growth) method or the Terminal Multiple method. To use the Gordon Growth method, we must choose an appropriate rate by which the company can grow forever. This growth rate should be modest, for example, average long-term expected GDP growth or inflation. To calculate terminal value we multiply the last year’s free cash flow (year 5) by 1 plus the chosen growth rate, and then divide by the discount rate less growth rate.

The second method, the Terminal Multiple method, is the one that is more often used in banking. Here we take an operating metric for the last projected period (year 5) and multiply it by an appropriate valuation multiple. This most common metric to use is EBITDA. We typically select the appropriate EBITDA multiple by taking what we concluded for our comparable company analysis on a last twelve months (LTM) basis.

Now that we have our projections of free cash flows and terminal value, we need to “present value” these at the appropriate discount rate, also known as weighted average cost of capital (WACC). For discussion of calculating the WACC, please read the next topic. Finally, summing up the present value of the projected cash flows and the present value of the terminal value gives us the DCF value. Note that because we used unlevered cash flows and WACC as our discount rate, the DCF value is a representation of Enterprise Value, not Equity Value.

Thank you Star, if you use EBIT(1-T) to calculate the unlevered FCF for your DCF, is that going to result in enterprise value, or equity value?

Sorry if these seem simple, its the simple ones I can't afford to botch.

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In order to use the CAPM to calculate our cost of equity, we need to estimate the appropriate Beta. We typically get the appropriate Beta from our comparable companies (often the mean or median Beta). However before we can use this “industry” Beta we must first unlever the Beta of each of our comps. The Beta that we will get (say from Bloomberg or Barra) will be a levered Beta.

Recall what Beta is: in simple terms, how risky a stock is relative to the market. Other things being equal, stocks of companies that have debt are somewhat more risky that stocks of companies without debt (or that have less debt). This is because even a small amount of debt increases the risk of bankruptcy and also because any obligation to pay interest represents funds that cannot be used for running and growing the business. In other words, debt reduces the flexibility of management which makes owning equity in the company more risky.

Now, in order to use the Betas of the comps to conclude an appropriate Beta for the company we are valuing, we must first strip out the impact of debt from the comps’ Betas. This is known as unlevering Beta. After unlevering the Betas, we can now use the appropriate “industry” Beta (e.g. the mean of the comps’ unlevered Betas) and relever it for the appropriate capital structure of the company being valued. After relevering, we can use the levered Beta in the CAPM formula to calculate cost of equity.

Unlevered Beta =
Levered Beta / (1 + ((1 - Tax Rate) x (Debt/Equity)))

Levered Beta =
Unlevered Beta x (1 + ((1 - Tax Rate) x (Debt/Equity)))

A lot of people don't understand the difference, nor can they offer you an informed, clear explanation, as b2's retarded answer shows. Guess some people get so used to BSing they forget when they don't have to! That kid must have forgotten the simple basics of finance because none of his staffers trust him with any important work. At least he's immaculate when it comes to spreading those comps and preparing those pibs!

When valuing the firm we take unlevered cash flows (ie, cash flow before the effects of financing ie interest payments, etc.). We account for the capital structure and its effects on value later in the discount rate.

This is the proper method, though some banks may change things because they 1. don't care explaining why not this/that to their busch league analysts (b2) or 2. none of their clients ultimately care about the theory. They're there for a sales pitch. Either way its worth knowing it if you have a genuine interest in learning the intuition behind it.

unlevered cash flow, or "Free Cash Flow to The Firm"

FCFF = EBIT(1-T) + Dep./Amort. - change in non-cash NWC - capex

Oh yeah, some people don't understand that NOPAT = EBIT(1-T), just so there's no confusion. And the proper way is to consider non-cash net working capital needs, because things like cash are non-operating assets. We're concerned with valuing the operating assets of the firm, and can then add back any non-operating assets like cash later, after we've discounted these cash flows (since including cash in this calculation and discounting it by the cost of capital doesn't make sense).

As for the other one, I've seen that too, but remember:

Net Income + D/A = NET cash flow. We don't really use this because it is a levered cash flow. That is, it is effected by the financing mix of the firm (if we have more debt, we're probably paying more interest, hence changing the figure. If we used this when valuing the firm, we'd be double counting the financing effects.

Now, that said, we DO use NI as a proxy for cash flow when we are trying to find the free cash flow to equity holders, or the levered cash flows (cash flow left to equity holders after all non-equity claims have been paid), which can be simply stated:

FCFE = Net Income + D/A - change in non-cash NWC - capex + (new debt issued - debt repayment)

This is the cash flow that is available to paid out as dividends to common equity holders. Of course, for any number of reasons, it rarely is. You can change this formula here and there for firms with unique debt repayment schedules, financing mixes, etc., but this is the general model)

As for beta:

You never discount cash flows by using unlevered beta in the discount rate (though this changes for APV-adjusted present value, but that's not really what you're asking I don't think). The beta you find on finance sites/bloomberg/etc. are levered. So, the effects of the capital structure are included in the beta you or the fin. services firms get by taking the statistical figure from monthly returns, etc. Whether you need to unlever and relever it depends: the best practice is that when valuing a firm, you take the betas of the comps, unlever these betas at their firm's unique capital structures, and then take that pure-play, raw, unlevered, equity beta, or whatever else you want to call it, and relever using the capital structure you have for the firm you are valuing, or using the capital structure you expect your valuation target to have. So, when you plug that into the CAPM and the cost of equity into your cost of capital for the DCF, you are using a levered beta once again.

One thing you've gotta' remember is if you don't wanna end up in the depressing 65th percentile like b2 here, make sure you understand the methodology beyond the formula. This may be difficult if you wasted college studying some BS like art history and realized at the last minute you wanted to enter the world of finance when you realized the kids in your mansion-neighborhood were all going into banking and you wanted to "be one of the big boys" too, but I don't think you're as bad off as b2 yet man, so good luck, hope I didn't confuse anything there. Hope this helps! I think as always, damodaran or ibanking faq have the clearest, non-ranty explanations. Refer to those sources.

@Star... you just copy/paste plagiarize from ibankingfaq.com? :(
@the other retard... HAHAHHAHA, discount by CAPM beta... HAHAHAHHA... wow, I seriously hope no one takes your retarded advice. No wonder you still don't have a job.

I keep my explanations brusque b/c anyone with reasonable intelligence and finance skills should be able to understand. I don't feel like teaching kindergarten finance to tier-3 idiots.

Obviously you never got the chance to work with an APV, where you value the firm in chunks. The unlevered value of the firm is discounted at the unlevered cost of equity, using an unlevered beta. APV is a variant sometimes used in private equity but you wouldn't have a clue about that, because you never have and never will get to enjoy the prestige it offers you. Your prestige doesn't go beyond the cheeto-crumb scattered desk you're forced to sit at because no one invites you to go to lunch. I feel bad for you, I truly do! Don't worry little buddy, I'm sure your parents haven't changed the Aladdin bed sheets you never quite grew out of! Your career is brusque, bro. Almost as depressing as the low-income dead-end jobs your genetic-cesspool parents have back in New England!

Do you think they use APV in banking???? HAHAHAHHAHAHAHHAHAHA wow... Yes, I learned that stupid theory in finance101 also - no you're not special - yes, your interviewer would "LMAO" at you once you mention those three letters.... hahahahahhaha... get back to the back of the unemployment line!

Dude, playing with your head makes it worth listening to more and more of your sad story leak out in nuance: from your shitty life with your poor, clearly neglecting parents to your sad attempts to justify yourself as a prestigious banker! Love it man, keep it coming. I can't see you crying in denial on my computer, but god knows, I wish I could.

a 65th thinking that he cna "play with" a 99th? hahahahahha, I pay more for my apartment in a month than you make in an entire year! go cash your welfare check!

So how about you take your bickering to myspace or something... thanks for the help, but both of you are acting like you are in third grade.

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