Free Cashflow to Equity Models

In Chapter 11, while developing a framework for analyzing dividend policy we estimated the free cash flow to equity as the cash flow that the firm can afford to pay out as dividends, and contrasted it with the actual dividends. We noted that many firms do not pay out their FCFE as dividends; thus, the dividend discount model may not capture their true capacity to generate cash flows for stockholders. A more appropriate model is the free cash flow to equity model.

Setting up the Model

The FCFE is the residual cash flow left over after meeting interest and principal payments and providing for capital expenditures to maintain existing assets and to create new assets for future growth. The free cash flow to equity is measured as follows: FCFE = Net Income + Depreciation - Capital Expenditures - a Working Capital -Principal Repayments + New Debt Issues where a Working Capital is the change in non-cash working capital.

In the special case where the capital expenditures and the working capital are expected to be financed at the target debt ratio 6, and principal repayments are made from new debt issues, the FCFE is measured as follows:

FCFE = Net Income + (1-6) (Capital Expenditures - Depreciation) + (1-6) a Working Capital

There is one more way in which we can present the free cash flow to equity. If we define the portion of the net income that equity investors reinvest back into the firm as the equity reinvestment rate, we can state the FCFE as a function of this rate. Equity Reinvestment Rate

_ (Capital Expenditures - Depreciation + A Working Capital) (1- #)

Net Income

FCFE = Net Income (1 - Equity Reinvestment Rate)

Once we estimate the FCFE, the general version of the FCFE model resembles the dividend discount model, with FCFE replacing dividends in the equation: Value of the Stock = PV of FCFE during high growth + PV of terminal price t=n

E(FCFE)t , Terming Value- _e(fcfeU

where the expected free cashflows to equity are estimated each year for the high growth period, r is the cost of equity and gn is the stable growth rate.

There is one key difference between the two models, though. While the dividends can never be less than zero, the free cashflows to equity can be negative. This can occur even if earnings are positive, if the firm has substantial working capital and capital expenditure needs. In fact, the expected free cashflows to equity for many small, high growth firms will be negative at least in the early years, when reinvestment needs are high, but will become positive as the growth rates and reinvestment needs decrease.

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