MIDLANDS STATE UNIVERSITY

FACULTY OF BUSINESS SCIENCES

DEPARTMENT OF ECONOMIC SCIENCES

FINANCIAL ENGINEERING: MECO735

NAME SURNAME REG NO//

Qoqusapho G.K Makwati R241326T

Individual Presentation

Lecturer: Ms M. Mango
Free Cash Flow Definition

Free Cash Flow (FCF) is a significant financial metric that measures the cash generated by a
company's operations after accounting for capital expenditures necessary to maintain and expand
its asset base. It can be expressed as the amount of money left over for debt repayment,
dividend payments to shareholders, or operational reinvestment.

Free cash flow is a key indicator of a firm's financial health and managerial performance. It
quantifies the amount of money made by a business after capital expenditures required to
preserve and grow its asset base have been deducted.

Computing FCFF from Net Income

Free cash flow to the firm (FCFF) is the cash flow available to the company's capital providers
following the payment of all operational costs (including taxes) and operating investments

The company's free cash flow is expressed as shown below.

FCFF = Net income available to common shareholders +

Plus: Net Non-Cash Charges

Plus: Interest Expense times (1 – Tax rate)

Less: Investment in Fixed Capital

Less: Investment in Working Capital

This equation can be written more compactly as

FCFF = NI + NCC + Int(1 – Tax rate) – Inv(FC) – Inv(WC)

Computing FCFF from the statement of Cash Flows

To estimate FCFF by starting with cash flow from operations (CFO), we must recognise the
treatment of interest paid. If, as the case with U.S. GAAP, the after-tax interest was taken out of
net income and out of CFO, after-tax interest must be added back in order to get FCFF. So free
cash flow to the firm, estimated from CFO, is

FCFF = Cash Flow from Operations

Plus: Interest Expense times (1 – Tax rate)

Less: Investment in Fixed Capital

Or as:

FCFF = CFO + Int(1 – Tax rate) – Inv(FC)

Understanding Noncash Charges

The best place to find historical non-cash charges is to review the firm’s statement of cash flows.
Some common non-cash charges and the adjustments to net income to get cash flow include:

Non cash item Adjustment to NI to arrive at CF

Depreciation Added back

Amortisation expense and impairment of intangibles Added back
Restructuring charges (expenses) Added back
Restructuring charges (income resulting from reversals) Subtracted
Losses on non-operating activity Added back
Gains on non-operating activity Subtracted
Amortisation of long term bond discounts Added back
Amortisation of long term bond premium Subtracted
Deferred taxes Added back but warrants special
attention

Deferred taxes occur as a result of a discrepancy in when income and spending are reported on
the business' tax return. The amount of cash taxes paid is not the same as the income tax expense
subtracted when calculating net income for financial reporting purposes. These discrepancies
between book and taxable income ought to offset each other over time and cease to affect total
cash flows. In this instance, deferred taxes wouldn't need to be adjusted.

If the analyst’s purpose is forecasting and he seeks to identify the persistent components of
FCFF, then it is not appropriate to add back deferred tax changes that are expected to reverse in
the near future. However, in certain situations, a business might be able to continue postponing
taxes until a much later time. An analyst adjustment, or add-back, is justified if a business is
expanding and has the capacity to permanently postpone its tax obligations.

Computing Free Cash Flows to Equity (FCFE) from FCFF

Free cash flow to equity is cash flow available to equity holders only. It is therefore necessary to
reduce FCFF by interest paid to debt holders and to add any net increase in borrowing (subtract
any net decrease in borrowing).

FCFE = Free cash flow to the firm

Less: Interest Expense times (1 – Tax rate)

Plus: Net Borrowing

Or

FCFE = FCFF – Int(1 – Tax rate) + Net borrowing

Computing FCFF and FCFE from

historical accounting data is
relatively straightfor-
ward. In some cases, these data
are used directly to extrapolate
free cash flow growth
in a single- stage free cash flow
valuation model. On other
occasions, however, the
analyst may expect that the
future free cash flows will not
bear a simple relationship
to the past. The analyst who
wishes to forecast future FCFF or
FCFE directly for such
a company must forecast the
individual components of free
cash flow. This section
extends our previous
presentation on computing FCFF
and FCFE to the more complex
task of forecasting FCFF and
FCFE.
One method for forecasting free
cash flow involves applying some
constant growth
rate to a current level of free
cash flow (possibly adjusted, if
necessary, to eliminate
non- recurring components). The
simplest basis for specifying the
future growth rate
is to assume that a historical
growth rate will also apply to the
future. This approach
is appropriate if a company’s
free cash flow has tended to
grow at a constant rate
and if historical relationships
between free cash flow and
fundamental factors are
expected to continue. Example7
asks that the reader apply this
approach to the Pitts
Corporation based on 2020 FCFF
of $155million as calculated in
Examples 5 and
Computing FCFF and FCFE from
historical accounting data is
relatively straightfor-
ward. In some cases, these data
are used directly to extrapolate
free cash flow growth
in a single- stage free cash flow
valuation model. On other
occasions, however, the
analyst may expect that the
future free cash flows will not
bear a simple relationship
to the past. The analyst who
wishes to forecast future FCFF or
FCFE directly for such
a company must forecast the
individual components of free
cash flow. This section
extends our previous
presentation on computing FCFF
and FCFE to the more complex
task of forecasting FCFF and
FCFE.
One method for forecasting free
cash flow involves applying some
constant growth
rate to a current level of free
cash flow (possibly adjusted, if
necessary, to eliminate
non- recurring components). The
simplest basis for specifying the
future growth rate
is to assume that a historical
growth rate will also apply to the
future. This approach
is appropriate if a company’s
free cash flow has tended to
grow at a constant rate
and if historical relationships
between free cash flow and
fundamental factors are
expected to continue. Example7
asks that the reader apply this
approach to the Pitts
Corporation based on 2020 FCFF
of $155million as calculated in
Examples 5 and
Computing FCFF and FCFE from
historical accounting data is
relatively straightfor-
ward. In some cases, these data
are used directly to extrapolate
free cash flow growth
in a single- stage free cash flow
valuation model. On other
occasions, however, the
analyst may expect that the
future free cash flows will not
bear a simple relationship
to the past. The analyst who
wishes to forecast future FCFF or
FCFE directly for such
a company must forecast the
individual components of free
cash flow. This section
extends our previous
presentation on computing FCFF
and FCFE to the more complex
task of forecasting FCFF and
FCFE.
One method for forecasting free
cash flow involves applying some
constant growth
rate to a current level of free
cash flow (possibly adjusted, if
necessary, to eliminate
non- recurring components). The
simplest basis for specifying the
future growth rate
is to assume that a historical
growth rate will also apply to the
future. This approach
is appropriate if a company’s
free cash flow has tended to
grow at a constant rate
and if historical relationships
between free cash flow and
fundamental factors are
expected to continue. Example7
asks that the reader apply this
approach to the Pitts
Corporation based on 2020 FCFF
of $155million as calculated in
Examples 5 and
Forecasting FCFF and FCFE

Computing FCFF and FCFE based upon historical accounting data is straightforward. Often
times, this data is then used directly in a single-stage DCF valuation model.

On other occasions, the analyst desires to forecast future FCFF or FCFE directly. In this case, the
forecast is done on the individual components of free cash flow.

There are a variety of ways in which to derive free cash flow on a historical basis, there are also
several methods of forecasting free cash flow. One approach is to compute historical free cash
flow and apply some constant growth rate. This approach would be appropriate if free cash flow
for the firm tended to grow at a constant rate and if historical relationships between free cash
flow and fundamental factors were expected to be maintained.

The other approach recognises that capital expenditures have two components; those
expenditures necessary to maintain existing capacity (fixed capital replacement) and those
incremental expenditures necessary for growth. When forecasting, the former are likely to be
related to the current level of sales, while the latter are likely to be related to the forecast of sales
growth.

Forecasting FCFF
Computing FCFF and FCFE from
historical accounting data is relatively
straightfor-
ward. In some cases, these data are used
directly to extrapolate free cash flow
growth
in a single- stage free cash flow valuation
model. On other occasions, however, the
analyst may expect that the future free
cash flows will not bear a simple
relationship
to the past. The analyst who wishes to
forecast future FCFF or FCFE directly for
such
a company must forecast the individual
components of free cash flow. This
section
extends our previous presentation on
computing FCFF and FCFE to the more
complex
task of forecasting FCFF and FCFE.
One method for forecasting free cash flow
involves applying some constant growth
rate to a current level of free cash flow
(possibly adjusted, if necessary, to
eliminate
non- recurring components). The simplest
basis for specifying the future growth rate
is to assume that a historical growth rate
will also apply to the future. This
approach
is appropriate if a company’s free cash
flow has tended to grow at a constant rate
and if historical relationships between
free cash flow and fundamental factors
are
expected to continue. Example7 asks
that the reader apply this approach to the
Pitts
Corporation based on 2020 FCFF of
$155million as calculated in Examples
5 and
Computing FCFF and FCFE from
historical accounting data is relatively
straightfor-
ward. In some cases, these data are used
directly to extrapolate free cash flow
growth
in a single- stage free cash flow valuation
model. On other occasions, however, the
analyst may expect that the future free
cash flows will not bear a simple
relationship
to the past. The analyst who wishes to
forecast future FCFF or FCFE directly for
such
a company must forecast the individual
components of free cash flow. This
section
extends our previous presentation on
computing FCFF and FCFE to the more
complex
task of forecasting FCFF and FCFE.
One method for forecasting free cash flow
involves applying some constant growth
rate to a current level of free cash flow
(possibly adjusted, if necessary, to
eliminate
non- recurring components). The simplest
basis for specifying the future growth rate
is to assume that a historical growth rate
will also apply to the future. This
approach
is appropriate if a company’s free cash
flow has tended to grow at a constant rate
and if historical relationships between
free cash flow and fundamental factors
are
expected to continue. Example7 asks
that the reader apply this approach to the
Pitts
Corporation based on 2020 FCFF of
$155million as calculated in Examples
5 and
Computing FCFF and FCFE from
historical accounting data is relatively
straightfor-
ward. In some cases, these data are used
directly to extrapolate free cash flow
growth
in a single- stage free cash flow valuation
model. On other occasions, however, the
analyst may expect that the future free
cash flows will not bear a simple
relationship
to the past. The analyst who wishes to
forecast future FCFF or FCFE directly for
such
a company must forecast the individual
components of free cash flow. This
section
extends our previous presentation on
computing FCFF and FCFE to the more
complex
task of forecasting FCFF and FCFE.
One method for forecasting free cash flow
involves applying some constant growth
rate to a current level of free cash flow
(possibly adjusted, if necessary, to
eliminate
non- recurring components). The simplest
basis for specifying the future growth rate
is to assume that a historical growth rate
will also apply to the future. This
approach
is appropriate if a company’s free cash
flow has tended to grow at a constant rate
and if historical relationships between
free cash flow and fundamental factors
are
expected to continue. Example7 asks
that the reader apply this approach to the
Pitts
Corporation based on 2020 FCFF of
$155million as calculated in Examples
5 and
When forecasting free cash flows, analysts often simplify the estimation of FCFF and FCFE. The
equations used in computing free cash flows are restated as

FCFF = NI + Int (1 – Tax rate) - (Capital spending – Depreciation) – Inv(WC)

Which is equivalent to,

FCFF = EBIT (1 – Tax rate) – (Capital spending – Depreciation) – Inv(WC)

The components of FCFF in these equations are often forecasted in relation to sales. If preferred
stock dividends have been paid and net income is income available to common shareholders, the
preferred dividends must be added back just after tax interest expenses are.

Forecasting FCFE

When forecasting FCFE, analysts often make an assumption that the financing of the company
involves a “target” debt ratio (DR). They thus assume that a specified percentage of the sum of
net new investment in fixed capital (new fixed capital minus depreciation expense) and the
increase in working capital is financed based on a target DR. This assumption leads to a
simplification of FCFE calculations. Assuming that depreciation is the only noncash charge,
 FCFE = NI + NCC – InvFC – InvWC + Net borrowing, becomes

FCFE = NI – (InvFC – Dep) – InvWC + Net borrowing.

InvFC – Dep represents the incremental fixed capital expenditure net of depreciation. By
assuming a target DR, the need to forecast net borrowing is eliminated and can use the
expression:

Net borrowing = DR(InvFC – Dep) + DR(InvWC)

Using this expression, there is no need to forecast debt issuance and repayment on an annual
basis to estimate net borrowing. The FCFE equation becomes

FCFE = NI – (InvFC – Dep) – InvWC + (DR)(InvFC – Dep) + (DR)(InvWC)

OR

FCFE = NI – (1 – DR)(InvFC – Dep) – (1 – DR)(InvWC)

When building FCFE valuation models, the logic, that debt financing is used to finance a
constant fraction of investments, is very useful.

Single stage FCFMs

One method for forecasting free cash flow involves applying some constant growth rate to a
current level of free cash flow). Assuming that a previous growth rate will likewise apply to the
future is the most straightforward way to specify the future growth rate. This strategy is suitable
if a company's free cash flow has a history of growing steadily and if it is anticipated that the
linkages between free cash flow and fundamental elements will persist.

FCFF in any period is equal to FCFF in the previous period times (1 + g):

FCFFt = FCFFt–1 (1 + g).

The value of the firm if FCFF is growing at a constant rate is:

 FCFF1 FCFF0 (1  g )
Firm Value  
WACC  g WACC  g

Subtracting the market value of debt from the firm value gives the value of equity. Therefore:

Equity value = Firm value – Market value of debt

Single-stage, constant-growth FCFE valuation model

FCFE in any period will be equal to FCFE in the preceding period times (1 + g):

FCFEt = FCFEt–1 (1 + g).

The value of equity if FCFE is growing at a constant rate is:

FCFE1 FCFE 0 (1  g )
Equity Value  
r g r g

The discount rate is r, the required return on equity. The growth rate of FCFF and the growth rate
of FCFE are frequently not equivalent.

Two stage FCFMs

The two most popular versions of the two-stage FCFF and FCFE models are:

The growth rate is constant (or given) in stage one, and then it drops to the long-run sustainable
rate in stage two. The growth rates are declining in stage one, reaching the sustainable rate at the
beginning of stage two. This latter model is like the H model for dividend valuation.

The growth rates can be applied to different variables. The growth rate could be the growth rate
for FCFF or FCFE, or the growth rate for income (such as net income), or the growth rate could
be the growth rate for sales. If the growth rate were for net income, the changes in FCFF or
FCFE would also depend on investments in operating assets and financing of these investments.
When the growth rate in income declines, such as between stage one and stage two, investments
in operating assets will probably decline at the same time. If the growth rate is for sales, changes
in net profit margins as well as investments in operating assets and financing policies will
determine FCFF and FCFE.

A general expression for the two-stage FCFF valuation model is

n
FCFFt FCFFn 1 1
Firm Value=  (1+WACC) + (WACC-g ) (1+WACC)
t 1
t n

The summation gives the present value of the first n years’ FCFF. The terminal value of the
FCFF from year n+1 onward is FCFFn+1 / (WACC – g), which is discounted at the WACC for n
periods. Subtracting the value of outstanding debt gives the value of equity. To obtain the value
per share the total value of equity id divided by the number of outstanding shares. The general
expression for the two-stage FCFE valuation model is

n
FCFE t FCFE n 1 1
Equity   t 1 (1  r )t

r  g (1  r ) n

The summation is the present value of the first n years’ FCFE, and the terminal value of
FCFEn+1 / (r – g) is discounted at the required rate of return on equity for n years. The value per
share is found by dividing the total value of equity by the number of outstanding shares

Three- stage free cash flow models

It assumes that:

 The company will see rapid growth during a specific time frame, often three to seven
years.
  After the phase of higher growth, there will be a transition period during which the
growth rate will decrease linearly.

 The transition period will be followed by a stable growth forever.

The three-stage models are an extension of the two-stage models. These models are appropriate
when cash flow streams change from year to year. There are two versions of three-stage FCF
models. In one version, there is a constant growth rate in each of the three stages. The growth
rates could be for sales, profits, and investments in fixed and working capital. A simpler model
would apply the growth rate to FCFF or FCFE. A second common model is a three-stage model
with constant growth rates in stages 1 and 3 and a declining growth rate in stage 2. Again, the
growth rates could be applied to sales or to FCFF or FCFE. Whilst future FCFF and FCFE are
unlikely to follow the assumptions of either of these three- stage growth models, analysts often
find such models to be useful approximations.

Below is an example that explains three stage model:

[extracted from CFA Institute document on comprehensive overview of free cash flow
valuation techniques]

Strengths of three stage growth model

 Can accommodate a variety of patterns of future dividend streams. Even though they
may not replicate the future dividends exactly, they can be a useful approximation.
 The expected rates of return can be imputed by finding the discount rate that equates the
present value of the dividend stream to the current stock price.
 Using a model forces the analyst to specify assumptions (rather than simply using
subjective assessments). This allows analysts to use common assumptions, to understand
the reasons for differing valuations when they occur, and to react to changing market
conditions in a systematic manner.

Conclusion
Free Cash Flow (FCF) valuation models are crucial instruments in financial analysis and
investment valuation, providing a basis for assessing a company's intrinsic worth based on its
ability to generate cash flows. FCF models concentrate on the cash that a business makes after
deducting capital expenditures required to preserve or grow its asset base, in contrast to standard
earnings-based models, which can be impacted by accounting procedures and non-cash elements.

Question 3

MV (debt ) MV (equity )
WACC  rd (1  Tax rate )  re
3.1 MV (debt )  MV (equity ) MV (debt )  MV (equity )

= (400 000 000/1000 000 000) * 0.06 (1-0.3333) + 100 000 000/1000 000 000) *0.06 +
(500 000 000/1000 000 000) * 0.14

= 0.006 + 0.016 + 0.07

= 0.092

=9.2%

3.2 FCFF = NI + NCC + Int(1 – Tax rate) + Preferred dividends– Inv(FC) – Inv(WC)

= 120 000 000 + 44 000 000 + 42 000 000 (1 – 0.3333) + 9 000 000– 77 000 000 – 25
000 000

= 120 000 000 + 44 000 000 + 42 000 000 * 0.6667 + 9 000 000 – 77 000 000 – 25 000
000

=120 000 000 + 44 000 000 + 28 001 400 + 9 000 000-77 000 000 – 25 000 000

=$99 001 400

3.3 a) Value of the firm

= 90 001 400(1 + 0.046) / (0.092 – 0.046)

= 94 141 464.40 / 0.046

= $2 046 553 574

3.3 b) Value of the equity = Firm Value – Market Value of Debt – Preferred Stock

= 2 046 553 574 – 400 000 000 – 100 000 000

= $1 546 553 574

4. FCFE = NI + NCC – Inv(FC) – Inv(WC) + Net borrowing

= 120 000 000 + 44 000 000 – 77 000 000 – 25 000 000 + 35 000 000

= $97 000 000

5. Value of the equity:

= 97 000 000 (1 + 0.0575) /0.14 – 0.0575

= 102 577 500/0.0825

= $1 243 363 636

References

ACCA (2025) Strategic Professional – Options, Advanced Financial Management. Study Text.
Kaplan Publishing UK

Bodie, Z., Kane, A. and Marcus, A.J. (2004) Essentials of Investments. McGraw-Hill, New
York. 439

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