Chapter 9
Free Cash Flow Valuation
OBJECTIVES
How to estimate truly incremental cash flows.
How to estimate free cash flow to firm and free cash flow to equity.
What are some accepted principles in estimating free cash flow and NPV?
What is the impact of debt financing and inflation on NPV?
Why do alternate measures of project profitability like NPV and IRR give conflicting
results and how to deal with them?
How should projects with unequal lives be evaluated?As mentioned in the last chapter, the DCF methodology is widely used to evaluate capital projects. In the
DCF approach, the value of the project is the future expected cash flows discounted at a rate that reflects the
riskiness of the projected cash flows. The DCF methodology is founded on the principle that it is inappropriate
to capitalize earnings per se. One must also take into account the investment required to generate those
earnings. Consequently, cash flows are obtained by deducting net capital expenditure and incremental working
capital investment from net operating profits after taxes. The steps involved in the valuation are:
Step 1: Determine Free Cash Flow
Free cash flow is the cash flow available to all investors in the company—both shareholders and bondholders—
after consideration for taxes, capital expenditure and working capital investment.
Free cash flow = NOPAT + Depreciation – Capital expenditure- (+) Increases (Decreases) in Working capital investment
where NOPAT = Net operating profit after tax
= Earnings before interest but after taxes
= EBIT (1 – Tax rate); and
EBIT = Revenue – Cost of goods sold – Operating expenses – depreciation.
Estimation of cash flows requires NOPAT, Capital expenditure and Net working capital. In calculating
NOPAT, interest is not deducted because the discount rate, WACC, incorporates after-tax cost of debt.