Growth in different parts of the forecast horizon

The University of Sydney Page 1
Presented by
Craig Mellare
University of Sydney Business School
Topic 6A Free Cash Flows in the
Discounted Cash Flows model
The University of Sydney Page 2
Learning Outcomes
Free Cash Flows (FCFs)
What are FCFs?
FCF Firm and Equity
How are FCFE and FCFF computed?
Leveraging and FCFs
Terminal Value
Defining a forecast horizon
The rate of growth in different parts of the forecast horizon
The University of Sydney Page 3
Back to Basics the DCF
Intrinsic value of a firm = PV of expected cash flows.
DCF relies on positive cash flows over the life of the asset and
value is determined by the magnitude and timing of cash flows.
Why cash flows?
Why not earnings measures?
( ) ( ) ( ) ( )
1 r
CF … 1 r
1 r
1 r
CF Value
+ =
The University of Sydney Page 4
Firm vs. Equity Valuation
Free cash flows (FCF) represent the cash available for distribution to all stakeholders of the
In other words, operating cash flow less capital expenditures and non cash working capital.
It is the residual cash flow after all expenses necessary to keep the firm growing at its current rate.
Free Cash flow to the Firm (FCFF): is the cash flow available to the companys suppliers of
capital after all operating expenses have been paid and necessary investments in working
capital and fixed capital have been made.
Known as the Invested Capital method
Free Cash flow to Equity (FCFE): is the cash flow available to the companys common equity
holders after all operating expenses have been paid and necessary investments in working
and fixed capital have been made.
Known as the Direct Equity method
FCFE can be calculated by subtracting the value of (usually debt and
preferred stock) from FCFF.
The University of Sydney Page 5
Free Cash Flow
= Cash flow available to common stockholders
+ Debtholders
+ Preferred stockholders
Free Cash Flow to the Firm
= Cash flow available to common stockholders
Free Cash Flow to Equity
The University of Sydney Page 6
Free Cash Flow to Equity (FCFE)
FCFE is not a radical departure from the traditional dividend discount model.
The primary difference between models lay in the definition of cash flows.
FCFE = potential dividends paid (depends on firms dividend policy).
DDM = actual/expected dividends paid.
When firms pay dividends FCFE, the values from the two models will be different.
More common that value from FCFE model > DMM model.
Which is more appropriate for valuation?
The University of Sydney Page 7
Free Cash Flow to Equity (FCFE)
Valuations using FCFE:
Use the Dividend Discount Model (Gordon):
a) For firms which pay dividends (and repurchase stock) which are close to the FCFE (over an extended
b) For firms where FCFE are difficult to estimate (e.g. Banks and Financial Service companies).
Use the FCFE Model:
a) For firms which pay dividends which are significantly higher or lower than the FCFE.
b) For firms where dividends are not available (IPOs, private companies).
The University of Sydney Page 8
Calculations FCFE (Unlevered Firm)
(1 – T) + DA -WC CAPEX
Since interest expense = 0
FCFEUnlevered Firm = NI + DA WC CAPEX
EBIT: Earnings before interest and taxes
EBIT(1 – T): After-tax operating income or net operating profit after tax (NOPAT)
T: Tax rate
DA: Depreciation and amortisation expense
WC: Change in net working capital
CAPEX: Capital expenditures for property, plant, and equipment
NI: Net Income
The University of Sydney Page 9
Components of FCFE – Earnings
A companys accounting earnings are not unrelated to its free cash flow.
Earnings are the result of taking the cash flows generated by a firms operating and
investing activities, and accruing or deferring certain cash flows to earlier or later periods.
These accruals and deferrals are designed to facilitate performance evaluation, rather than to
obfuscate the analysis of free cash flow.
To the extent that we start with accounting earnings in a base year, it is worth considering the
following questions:
Are there any one-time charges that might be depressing income in the base year or onetime earnings that might be increasing income in the base year?
Are the earnings negative, and if so, why?
Are there any financial or capital expenses intermingled with operating expenses?
The University of Sydney Page 10
Components of FCFE Non Cash Charges
Depreciation and Amortisation expense (DA)
Do not represent an actual cash payment
Arises out of the matching principle of accrual accounting, matches expenditures
made for long-lived assets (plant, machinery and equipment) against the
revenues they help generate.
The actual expenditure of cash may have taken place many years earlier when
the assets were acquired.
Other items like Restructuring expense (subtracted out), capital gains (subtracted
out), employee option exercise (added back), deferred taxes (added back).
The University of Sydney Page 11
Components of FCFE Net Capital Expenditures
Net capital expenditures sustain productive capacity and provide for growth firms
invest in long-lived assets
Maintenance CAPEX: Assets physically wear out and need replacement
Growth CAPEX: To achieve growth in future cash flows firms require added
capacity through investments in new PPE and acquisitions of businesses
CAPEX can be calculated by analysing how net PPE on the balance sheet changes
over time
Net property, plant, and equipment is equal to the difference in the
accumulated cost of all property, plant, and equipment (gross PPE) less the
accumulated depreciation for those assets
e.g. CAPEX(2020) = Net PPE (2020) Net PPE(2019) + Depn Expense (2020)
The University of Sydney Page 12
Components of FCFE Net Capital Expenditures (CAPEX)
In general, net CAPEX will be a function of how fast a firm is growing or expected to
High growth firms will have much higher net capital expenditures than low growth firms.
Remember product life cycle.
Assumptions about net capital expenditures should NEVER be made independently
of assumptions about growth in the future.
Remember that one-time or unusually high expenditures (perhaps associated with
equipment repairs) should be considered non-recurring for your valuation.
The University of Sydney Page 13
Components of FCFE Change in Working Capital
In accounting terms, working capital (WC) is the difference between current assets and
current liabilities where:
Current Assets = inventory, cash, accounts receivable
Current Liabilities = short term debt, current portion of long-term debt, accounts
In finance, we use a simpler approach whereby WC is the difference between non-cash
current assets and non-debt current liabilities.
Current Assets = inventory, accounts receivable
Current Liabilities = accounts payable
Any investment in this measure of working capital ties up cash. Therefore, any increase
(decrease) in working capital will reduce (increase) cash flows in that period.
When forecasting future growth, it is important to forecast the effects of such growth on
working capital needs, and building these effects into the cash flows.
The University of Sydney Page 14
Components of FCFE Change in Working Capital
Changes in net working capital (WC)
Investments in current assets used in
a firms operations are partially
financed by increases in current
The end result is an outlay for
working capital equal to the change
in operating net working capital
We may not want to always exclude
cash and marketable securities
because some firm require liquidity
to support operations/growth.
1Referred to as change rather than increase since the change can be both positive and negative.
The University of Sydney Page 15
Calculating FCFE Levered Firm
FCFE = (EBIT-I)(1 – T) + DA – CAPEX – WC P + NP
Which is the same as:
(EBIT I)(1 – T): Net income after taxes
NI: Net Income
P: Principal payments on the firms outstanding debt
NP: Net proceeds from the issuance of new debt
When a firm uses debt the two cash flow consequences are net proceeds (inflow) and
cash outlays for principal and interest payments. Since interest expense is tax
deductible, it reduces the taxes the firm has to pay.
The University of Sydney Page 16
What impact does borrowing have on FCFE?
Borrowing to finance an investment results in financial leverage
This will have some impact on the interest tax shields and reduce the cash flow
available to equity.
Therefore, the risk of uncertain cash flows must be absorbed by the equity
Because of the higher risk, shareholders require higher rates of return to entice
them to invest in levered projects
In summary, you can continue to borrow (hence increase leverage) which will pump
up your FCFE but at the other end of the ledger your levered beta will increase
thereby generating a higher discount rate.
Dividends and share repurchases are uses of these cash flows so do not affect free
cash flow.
The University of Sydney Page 17
Calculating FCFF
Combines the cash flow available for distribution to all the firms sources of
Where are the tax-savings from interest payments in this cash flow?
This can also be expressed in the following way:
FCFF = NI + DA + Interest(1- Tax Rate) WC CAPEX
NI = (EBIT-Interest) x (1-Tax Rate) = EBIT(1-Tax Rate) Interest (1-Tax Rate)
The University of Sydney Page 18
Computing FCFF from the Statement of Cash Flows
Analysts frequently use cash flow from operations, taken from the statement
of cash flows, as a starting point to compute free cash flow because cash
flow from operations (CFO) incorporates adjustments for expenses (such as
depreciation and amortisation) as well as for net investments in working
Cash flow statements may be useful to the end user because for such items
like interest expense they allow the company to classify it as either an
operating or financing activity.
To estimate FCFF by starting with CFO:
FCFF = CFO + Interest(1-Tax Rate) – CAPEX
The University of Sydney Page 19
Equity v Firm Valuation
Use Equity Valuation:
a) For firms which have stable leverage, whether high or not, and
b) If equity (stock) is being valued.
a) For firms which have leverage which is too high (or too low) and expect to change
leverage over time.
This is because debt payments and issues do not have to be factored in the cash flows and the discount
rate (cost of capital) does not change dramatically over time.
b) For firms where you may have partial information on leverage (e.g. interest
expenses are missing).
c) In all other cases where you are interested in valuing the firm (i.e. value consulting).
The University of Sydney Page 1
Presented by
Craig Mellare
University of Sydney Business School
Topic 6B Terminal Value
The University of Sydney Page 2
Learning Objectives
What is terminal (continuing) value?
How do we determine the length of the forecast horizon?
What are the different ways of estimating terminal value?
What is a reasonable growth rate?
What are some alternative ways of thinking about the growth rate?
The University of Sydney Page 3
Closing out a Valuation
A publicly traded firm is assumed to have an indefinite life. The value is therefore equal
to the present value of its future cash flows.
In other words:
Since we cannot estimate cash flows forever, we estimate cash flows for a growth period
and then estimate a terminal value to capture the value at the end of the period.
We are therefore making simplifying assumptions about a firms performance (constant
rate of growth on existing and new capital)
= +
t t
(1 r)
CF Value
t N
t t
(1 r)
(1 r)
CF Value
+ = =
The University of Sydney Page 4
In other words
To estimate a companys value, we separate a
companys expected cash flow into two periods
and define the companys value as follows:
The second term is the continuing value: the
value of the companys expected cash flow
beyond the explicit forecast period.
Present Value of Cash Flow
during Explicit Forecast Period
Present Value of Cash Flow
after Explicit Forecast Period
Value = +
Explicit Forecast
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
$ million
The University of Sydney Page 5
Terminal (continuing) value
We prioritise the terminal value because it represents a sizeable portion of any valuation
In the same way that non-current assets (fixed assets) make up a significant proportion of
total assets, so does the terminal value for an intrinsic valuation.
We should be careful, however, not to prioritise the terminal value over the forecast horizon
valuation just because it constitutes a bigger proportion of the valuation. There are at least two
reasons for this:
1) Estimates of continuing value depend on decisions and assumptions made in the earlier
2) A larger continuing value does not mean that more value has been created in this period; Rather it just means that the amount of economic profit generated in the period is higher than in the forecast horizon period.
If our cash inflows in the short-term are offset by investment in fixed assets (cash outflows
in the same period), then our future cash-flows, and hence our continuing value is a function
of the building blocks we put in place during the forecast horizon period.
The University of Sydney Page 6
How do we estimate Terminal Value?
Terminal Value can be estimated a number of ways. The most common approaches
1. Stable Growth Model
This method requires you to make a judgement about when a firm will grow at a stable
rate for which it will need to sustain.
Gordon Growth Model
2. Multiple Approach
Easiest approach but makes the valuation a relative one.
3. Liquidation Value
Most useful when assets are separable and marketable.
The University of Sydney Page 7
Gordon Growth Model
The value of continuing cash flows can be determined using the Gordon
Growth model. This looks like:
It factors in the continuing free cash flow of the firm, the associated cost
of capital, and the perpetual growth rate on cash flows.

The University of Sydney Page 8
Stable Growth Model
We are we assuming in this model:
A stable rate of growth?
A stable capital structure?
Fixed/Stable taxes?
Does it make sense to assume fixed/stable assumptions regarding
these factors?
What about Cost of equity?
Lever an unlevered beta with the D/E expected for the continuing
The University of Sydney Page 9
How to get the right terminal value
1. Select a reasonable growth rate
2. Select a reasonable forecast horizon
3. Think about the return on invested capital
4. Be consistent in your model
The University of Sydney Page 10
Think about the make-up of growth rates
Remember that growth is a function of:
Return on Invested Capital (new + old)
The level of re-investment (versus payout)
In stable growth, you cannot count on efficiency delivering growth and you have to
re-invest to deliver the growth rate that you have forecast.
Therefore, your reinvestment rate in stable growth will be a function of your stable growth
rate and what you believe the firm will earn as a return on capital in perpetuity.
There is some contention about this issue.
Some prominent authors have taken the position that the return on capital cannot exceed
the cost of capital forever.
The University of Sydney Page 11
Time Are all forecast horizon periods the same?
Reaching a steady state causes all sorts of confusion
Does this mean that a company ceases to earn in excess of the cost of capital or is it
simply confined to new investment.
The explicit forecast period must be long enough for the company to reach a steady state,
defined by the following characteristics:
The company grows at a constant rate and reinvests a constant proportion of its operating profits into the business each year.
The company earns a constant rate of return on new capital invested.
The company earns a constant return on its base level of invested capital.
In general, an explicit forecast period of 5-10 years is generally recommended perhaps
longer for cyclical companies or those experiencing very rapid growth.
Using a short explicit forecast period, such as five years, typically results in a significant undervaluation of a company or requires
heroic long-term growth assumptions in the continuing value.
We should also remember to undertake a qualitative assessment.
Porters 5 forces, SWOT analysis.
The University of Sydney Page 12
Gray, Cusatis, Woolridge (GCW, 1999)
Set T = 1 year for boring companies which (1) operate in highly competitive, low
margin industries and (2) have nothing particular going for them.
Set T = 5 years for decent companies with reasonable reputations and propsects.
Set T = 7 years for good companies with good growth potential, brand names,
marketing channels, consumer recognition, or some other recongisable competitive
Set T = 10 years for great companies with substantial competitive advantages like
strong marketing power, brand names, or technology.
The University of Sydney Page 13
Looking forward
There is always going to be forecast error (uncertainty) associated with our
Certain industries and firms will be more volatile.
How do we handle this volatility from a valuation perspective?
Project/Firm Risk Analysis
Includes sensitivity, scenario, simulation analysis
What do we learn from this type of analysis?
The University of Sydney Page 14
The End
Next recording I will discuss
relative valuation models for
determining company value

Get Professional Assignment Help Cheaply

Buy Custom Essay

Are you busy and do not have time to handle your assignment? Are you scared that your paper will not make the grade? Do you have responsibilities that may hinder you from turning in your assignment on time? Are you tired and can barely handle your assignment? Are your grades inconsistent?

Whichever your reason is, it is valid! You can get professional academic help from our service at affordable rates. We have a team of professional academic writers who can handle all your assignments.

Why Choose Our Academic Writing Service?

  • Plagiarism free papers
  • Timely delivery
  • Any deadline
  • Skilled, Experienced Native English Writers
  • Subject-relevant academic writer
  • Adherence to paper instructions
  • Ability to tackle bulk assignments
  • Reasonable prices
  • 24/7 Customer Support
  • Get superb grades consistently

Online Academic Help With Different Subjects


Students barely have time to read. We got you! Have your literature essay or book review written without having the hassle of reading the book. You can get your literature paper custom-written for you by our literature specialists.


Do you struggle with finance? No need to torture yourself if finance is not your cup of tea. You can order your finance paper from our academic writing service and get 100% original work from competent finance experts.

Computer science

Computer science is a tough subject. Fortunately, our computer science experts are up to the match. No need to stress and have sleepless nights. Our academic writers will tackle all your computer science assignments and deliver them on time. Let us handle all your python, java, ruby, JavaScript, php , C+ assignments!


While psychology may be an interesting subject, you may lack sufficient time to handle your assignments. Don’t despair; by using our academic writing service, you can be assured of perfect grades. Moreover, your grades will be consistent.


Engineering is quite a demanding subject. Students face a lot of pressure and barely have enough time to do what they love to do. Our academic writing service got you covered! Our engineering specialists follow the paper instructions and ensure timely delivery of the paper.


In the nursing course, you may have difficulties with literature reviews, annotated bibliographies, critical essays, and other assignments. Our nursing assignment writers will offer you professional nursing paper help at low prices.


Truth be told, sociology papers can be quite exhausting. Our academic writing service relieves you of fatigue, pressure, and stress. You can relax and have peace of mind as our academic writers handle your sociology assignment.


We take pride in having some of the best business writers in the industry. Our business writers have a lot of experience in the field. They are reliable, and you can be assured of a high-grade paper. They are able to handle business papers of any subject, length, deadline, and difficulty!


We boast of having some of the most experienced statistics experts in the industry. Our statistics experts have diverse skills, expertise, and knowledge to handle any kind of assignment. They have access to all kinds of software to get your assignment done.


Writing a law essay may prove to be an insurmountable obstacle, especially when you need to know the peculiarities of the legislative framework. Take advantage of our top-notch law specialists and get superb grades and 100% satisfaction.

What discipline/subjects do you deal in?

We have highlighted some of the most popular subjects we handle above. Those are just a tip of the iceberg. We deal in all academic disciplines since our writers are as diverse. They have been drawn from across all disciplines, and orders are assigned to those writers believed to be the best in the field. In a nutshell, there is no task we cannot handle; all you need to do is place your order with us. As long as your instructions are clear, just trust we shall deliver irrespective of the discipline.

Are your writers competent enough to handle my paper?

Our essay writers are graduates with bachelor's, masters, Ph.D., and doctorate degrees in various subjects. The minimum requirement to be an essay writer with our essay writing service is to have a college degree. All our academic writers have a minimum of two years of academic writing. We have a stringent recruitment process to ensure that we get only the most competent essay writers in the industry. We also ensure that the writers are handsomely compensated for their value. The majority of our writers are native English speakers. As such, the fluency of language and grammar is impeccable.

What if I don’t like the paper?

There is a very low likelihood that you won’t like the paper.

Reasons being:

  • When assigning your order, we match the paper’s discipline with the writer’s field/specialization. Since all our writers are graduates, we match the paper’s subject with the field the writer studied. For instance, if it’s a nursing paper, only a nursing graduate and writer will handle it. Furthermore, all our writers have academic writing experience and top-notch research skills.
  • We have a quality assurance that reviews the paper before it gets to you. As such, we ensure that you get a paper that meets the required standard and will most definitely make the grade.

In the event that you don’t like your paper:

  • The writer will revise the paper up to your pleasing. You have unlimited revisions. You simply need to highlight what specifically you don’t like about the paper, and the writer will make the amendments. The paper will be revised until you are satisfied. Revisions are free of charge
  • We will have a different writer write the paper from scratch.
  • Last resort, if the above does not work, we will refund your money.

Will the professor find out I didn’t write the paper myself?

Not at all. All papers are written from scratch. There is no way your tutor or instructor will realize that you did not write the paper yourself. In fact, we recommend using our assignment help services for consistent results.

What if the paper is plagiarized?

We check all papers for plagiarism before we submit them. We use powerful plagiarism checking software such as SafeAssign, LopesWrite, and Turnitin. We also upload the plagiarism report so that you can review it. We understand that plagiarism is academic suicide. We would not take the risk of submitting plagiarized work and jeopardize your academic journey. Furthermore, we do not sell or use prewritten papers, and each paper is written from scratch.

When will I get my paper?

You determine when you get the paper by setting the deadline when placing the order. All papers are delivered within the deadline. We are well aware that we operate in a time-sensitive industry. As such, we have laid out strategies to ensure that the client receives the paper on time and they never miss the deadline. We understand that papers that are submitted late have some points deducted. We do not want you to miss any points due to late submission. We work on beating deadlines by huge margins in order to ensure that you have ample time to review the paper before you submit it.

Will anyone find out that I used your services?

We have a privacy and confidentiality policy that guides our work. We NEVER share any customer information with third parties. Noone will ever know that you used our assignment help services. It’s only between you and us. We are bound by our policies to protect the customer’s identity and information. All your information, such as your names, phone number, email, order information, and so on, are protected. We have robust security systems that ensure that your data is protected. Hacking our systems is close to impossible, and it has never happened.

How our Assignment Help Service Works

1. Place an order

You fill all the paper instructions in the order form. Make sure you include all the helpful materials so that our academic writers can deliver the perfect paper. It will also help to eliminate unnecessary revisions.

2. Pay for the order

Proceed to pay for the paper so that it can be assigned to one of our expert academic writers. The paper subject is matched with the writer’s area of specialization.

3. Track the progress

You communicate with the writer and know about the progress of the paper. The client can ask the writer for drafts of the paper. The client can upload extra material and include additional instructions from the lecturer. Receive a paper.

4. Download the paper

The paper is sent to your email and uploaded to your personal account. You also get a plagiarism report attached to your paper.

smile and order essay GET A PERFECT SCORE!!! smile and order essay Buy Custom Essay

Place your order
(550 words)

Approximate price: $22

Calculate the price of your order

550 words
We'll send you the first draft for approval by September 11, 2018 at 10:52 AM
Total price:
The price is based on these factors:
Academic level
Number of pages
Basic features
  • Free title page and bibliography
  • Unlimited revisions
  • Plagiarism-free guarantee
  • Money-back guarantee
  • 24/7 support
On-demand options
  • Writer’s samples
  • Part-by-part delivery
  • Overnight delivery
  • Copies of used sources
  • Expert Proofreading
Paper format
  • 275 words per page
  • 12 pt Arial/Times New Roman
  • Double line spacing
  • Any citation style (APA, MLA, Chicago/Turabian, Harvard)

Our guarantees

Delivering a high-quality product at a reasonable price is not enough anymore.
That’s why we have developed 5 beneficial guarantees that will make your experience with our service enjoyable, easy, and safe.

Money-back guarantee

You have to be 100% sure of the quality of your product to give a money-back guarantee. This describes us perfectly. Make sure that this guarantee is totally transparent.

Read more

Zero-plagiarism guarantee

Each paper is composed from scratch, according to your instructions. It is then checked by our plagiarism-detection software. There is no gap where plagiarism could squeeze in.

Read more

Free-revision policy

Thanks to our free revisions, there is no way for you to be unsatisfied. We will work on your paper until you are completely happy with the result.

Read more

Privacy policy

Your email is safe, as we store it according to international data protection rules. Your bank details are secure, as we use only reliable payment systems.

Read more

Fair-cooperation guarantee

By sending us your money, you buy the service we provide. Check out our terms and conditions if you prefer business talks to be laid out in official language.

Read more
error: Content is protected !!
Open chat
Need assignment help? You can contact our live agent via WhatsApp using +1 718 717 2861

Feel free to ask questions, clarifications, or discounts available when placing an order.
  +1 718 717 2861           + 44 161 818 7126           [email protected]
  +1 718 717 2861         [email protected]