Free Cash Flow Valuation

Hi,

I am using DCF/freecashflow to value two projects/firms. Both firms have no reinvestment needs and all cashflows are equal except that the first one pays out as dividends all the cash it earns. The second firm retains all the earnings in the banks and earns interest income on it.
The value of the interest income makes the second firm more valuable using the free cash flow approach (as dividends are ignored but interest income is added). However, this seems counter intuitive as would be better to distribute the excess cash in dividends.
If anyone can help in my understanding.

 

This is wrong. FCF ignores interest income / expense (since it's unlevered). FCFE would include the interest income, but any interest income should be less than the impact of holding on to the cash for extra discounting periods... standard equity discount rate (US): 10 - 16% which should be bigger than any interest income (usually modeled at 0.5%) so you're saying (1 + 0.005) / (1.14) > 1, which is false.

 
Best Response

I think you are confused.

The 'standard' DCF method is to take the present value of unlevered free cash flows; unlevered means you remove the effects of the company's capitalization structure from the cash flow stream. This means you back out interest expense and dividends, but you also back out interest income (unless you are valuing a bank or financial company).

The theory here is that you want to value the company's assets and operations independent of its debt and equity structure, and regardless of how much cash it has on hand. Interest income is coming from excess cash, not the company's operations. The excess cash can generate modest income, pay down debt to save future interest, or go out as a dividend - that is a capital structure decision, and should not affect the unlevered valuation method.

Crucially, you would apply the unlevered discount rate (typically the WACC) to these unlevered cash flows in order to value the assets.

If you want to do a free cash flow to equity valuation, then you would use the levered cash flows to equity and discount them at the cost of equity. This will result in a valuation of just the equity piece of the business, but in theory if you take the PV of unlevered cash flows at the WACC less the PV of debt service at the cost of debt, you should get to the roughly the same value as if you take the PV of cash flows to equity at the cost of equity (assuming the cost of equity and cost of debt were correctly incorporated into the WACC).

 

Thank you for your responses. I understand the FCFF, where you exclude the interest income, however I am still confused about FCFE. In FCFE as interest income is included, even if discounted back it would be better than having zero interest income (which is the case when they are paid as dividends and are not accounted for in the free cash flows). For example: assuming both firms have free cash flows (before interest income) of 100. One firm pays out 100 in dividends, the other firms puts 100 in the bank and earns 5 on it. So next year cash flows (assuming everything else the same and no reinvestment need) for the firms are now 100 (dividend paying) and 105 (interest on bank balance firm). So now we have to discount 100 vs 105 by the same discount rate, which would mean that the one not paying out dividends is more highly valued. Am I missing something?

 

I'll use your example. Think of it from the investor's perspective. We are at time = 0 and you have to choose whether to buy a piece of paper that will pay you $100 dividend at the end of year 1, or a $105 dividend at the end of year 2.

The key difference here is the reinvestment rate. You're telling me the company can generate a 5% return on reinvested capital. If I can generate >5% by reinvesting the cash myself, I will choose the $100 dividend at the end of year 1.

To see this mathematically, let's say my cost of equity is 15% and let's assume both companies just cease to exist after the first dividend payment.

Value of company A = $100 / (1 + 0.15)^1 = $87 Value of company B = $105 / (1 + 0.15)^2 = $79

So all else equal you would pay more for the company that returns cash sooner, even if it's less total cash returned.

Of course this is oversimplified - in reality the company would have regular dividend payments, reinvestment needs, a more complex capital structure, etc. But the general principle still holds:

  • Companies capitalize themselves with mix of debt and equity
  • Companies invest that mixed bag of capital in projects, and earn "project level returns" or "unlevered" returns
  • Companies then return cash to the various owners of capital by seniority in the cap structure
  • When it comes to equity, company can choose whether to distribute cash to equityholders or reinvest the cash

That last point is the tricky part. What should the company do? There is no right or wrong answer - it's case specific. If the company can confidently invest in growth opportunities that generate risk-adjusted returns above the cost of capital, then it should generate returns above the cost of equity as well (assuming the company has an optimal debt/equity mix) and will lead to even larger dividends for equityholders down the road. However if these opportunities generate lower than expected returns or fail to meet the hurdle rate, then equityholders would be better off just taking the cash out today. This is essentially why some growth companies reinvest all their cash while some mature companies pay steady dividends - it all comes down to what return the company can generate on new projects - as you start to run our of new opportunities, it becomes prudent to return a larger share of cash to shareholders.

 

Thanks a lot for your answer. I get it in the case you described where you are looking at actual cash returned to the investor. Still confused about the FCFE formula; wherein won't the 100 be considered in the 1st year in both cases as it would be free cash flow for the first year and wouldn't make a difference if it is paid out as dividend or reinvested? so basically it would be getting 100 in the first year for both cases and the 5 extra in the second. Sorry for maybe sounding dumb but i'm just going nuckfuts over the FCFE stuff.

 

You're confusing DCFs and LBOs. In a DCF, it makes more sense to pay the bare minimum in order to reduce the PV of these payments as you've alluded to. In an LBO, it is best to pay down debt as quickly as possible to reduce your future interest expense, freeing up cash flow to further pay down debt and increase your equity stake.

 

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