Models for Evaluating the Company on FCFE and FCFF basis

Models for Evaluating the Company on FCFE and FCFF basis Professor Gabriela-Victoria ANGHELACHE, PhD gabriela.anghelache@gmail.com Andreea NEGRU (CIOBANU), PhD Student Academy of Economic Studies, Bucharest Professor Gheorghe LEPĂDATU, PhD cilezbujor@yahoo.com Dimitrie Cantemir Christian University - Bucharest Abstract The basic idea when evaluating the companies on the basis of the cash-flows expected to e generated in the future consists of up-dating the available cash-flows at an appropriate rate of the expected yield. However, the matter gets complicated if considering the fact that we can utilize both the cash-flow available at the company level (FCFF), and the cash-flow available with the purpose of being distributed to the shareholders (FCFE). Key words: cash-flows, assets, financial indicators, capital, models, investment JEL Classification: G17, G32 The models based on FCFF calculate the to-date value of the company as sum of the cash-flows up-dated with the average weighted cost of the where: Vo(F) = current value of the company; N = number of years taken into account by the analysis; FCFFi = cash flow available generated in the year; WACC = average weighted cost of the capital, calculated as arithmetic weighted average of the company own capitals and the net cost of debts. The average weighted cost of the capital is the expected yield for all the assets generators of cash-flows that the company is utilizing in its activity. From a technical point of view, the company value represents in fact the value of its assets in exploitation, namely those assets which generate treasury flows. However, as shown by Fabozzi (2010), the significant non-operational assets, such as the excess of liquidities, the surplus of investment assets or the pieces of ground held for investments must be added to the estimate in order to get the total real value of the company. The FCFE models of evaluation calculate the present net value of the company (the value of the company own capitals) by up-dating the future cash-flows available for being distributed to the shareholders, the difference as against the model (1) consisting of the fact that the applied up-dating rate is the expected yield for the company own capitals, namely that yield required by the company shareholders for the capital they have committed to this one. The formula of evaluation is: 80

where V0(E) = present value of the company own capitals (the net value of the company); FCFEj = cash flow available for distribution to the shareholders in the year i; Re = expected yield of the company own capitals. Certainly, if considering the hypothesis that the company value is known, the value of the company own capitals can be calculated by deducting the market value of the company debts: (Vq(D)): V0(e) = V0(f)- V0(d). The differences between FCFF and FCFE reflect the differences between the financing structures of the companies and, consequently, the prospects of the different suppliers of capital. FCFE is easier to apply (and also more direct) when the structure of capital of the companies is not very volatile. But, on the other hand, if a company has a negative FCFE and a high level of debts, then FCFF represents the optimal choice. An interesting point is debated by Fabozzi and Markowitz (2010), who suggest that the perspective implied by the evaluation on FCFE basis is that of an investor exercising a significant influence, able to modify the company dividend policy, while the perspective implied by the evaluation on the basis of the up-dating of the expected future dividends (Gordon) is that of an investor who cannot influence directly the company dividend policy. To the extent that the investors are willing to pay a premium in order to control the company, then it is possible that a difference between the values of the same company, generated by the two models, occurs. The main reasons supporting the analysts choice to utilize the models FCFF and FCFE instead of the Gordon model of evaluation are the following: Many companies are paying low dividends or do not distribute dividends at all; The dividends are not necessarily consistent with the company long-term profitability, being paid in a discretionary manner; If a company is considered as a potential acquisition, then the evaluation on the basis of the future available cash-flows is correct as the new owners will hold the control on these cash-flows in the future; Lots of empirical researches emphasized the fact that there is a strong correlation between the company long-term profitability and the cashflows that are generated by its activity. Further on, we shall submit the modalities of calculating applied for the calculation of the financial indicators FCFF and FCFE. The available cash flow is calculated starting from the net outcome of the financial exercise, as follows: FCFF = NI + NCA + Int x (l - t)- WCI - FCI NI = the net outcome of the financial exercise70; NCA = adjustments for the non-monetary elements71; Int = interest expenses during the financial exercise; t = marginal quota for the tax on profit; WCI = investment in working capital; FCI = investment in fix assets. (4), where: We shall then detail the main characteristics of the four adjustments required by the available cash-flow with the company turnover. 81

The adjustments for the non-monetary elements (NCA) must be added to the net outcome (or deducted from this one) as we handle incomes or expenses, in order to reach the FCFF since they represent incomes/expenses that were taken into account when setting up the net outcome but that did not generate an effective input or output of liquidities. The most important non-monetary element which requires adjustment is given by the amortization of the company immobilized assets (corporal and non-corporal). Other examples of adjustments for non-monetary elements are represented by: - expenses with provisions for restructuring and other non-monetary losses (such as, for instance, the losses recorded in connection with the long-term sales of assets) must be added to the net outcome. However, as pointed out by Van Horne (2009), if the company records these expenses in order to cover future cash-flows, then the estimates for the future available cash-flows must be diminished accordingly; - reversals (takings-over on incomes) of the elements described by the previous point must be deducted from the net profit; - the postponed tax on profit, which results subsequent to the differences of synchronization between the reporting of the elements of incomes and expenses for accounting and fiscal purposes, must be carefully analyzed. In time, it is to be expected that these differences compensate to each other having, thus, no significant impact on the overall cash-flows. Nevertheless, if we expect that the liabilities concerning the postponed tax on profit keep on increasing (without getting reversed), these increases must be added back to the net profit. Symmetrically, the increases of claims concerning the postponed tax on profit that are not expected to be reversed must be deducted from the net outcome. The investment in fix assets (FCI) is not presented in the company cash-flow situation but they represent a cash outflow for the company. Thus, the FCI must be deducted from the net outcome when calculating the FCFF. The investment in fix assets represents a net amount, equal to the difference between the capital expenses (CAPEX) and the cashing from the assets long-term sales. Both elements are reported in the situation of the company cash-flows situation. If the company did not recorded assets long-term sales during the exercise, then the capital expenses will equal with the variant of the gross immobilizations balance in the balance-sheet; but, if such operations are recorded, then the eventual gains/losses at sale will be treated as non-monetary elements, as previously discussed. The investment in working capital (WCI) equals the variation of the company working capital (the requirements for circulating funds). Elements such as the available cash, cash equivalents, short-term debts and current portion of the long-term debts committed by the company are not taken into account. Of course, the diminishing of the company own capital will be treated with the sign +", because it represents a cash inflow for the company. The interest expenses represent elements of the profit and losses account, but they are basically representing a part of the cash-flow out of financing activities at the company disposal before it makes any payment in favor of its capital suppliers. Consequently, the interest expenses must be added to the net outcome in order to reach the available cash-flow at the company level; however the interest expenses are not entirely added but to the net value of taxation, because the deductibility of the interest expenses when establishing the net outcome of the company is reducing the tax on profit that is due by this one. The following table synthesizes the above comments: 82

Net outcome of the exercise (NI) +Adjustments for non-monetary elements (NCA) - WCI = Cash-flow from operations (CFO 76 ) + Int x (1-t) - FCI = FCFF + Net loans - Int x (1-t) = FCFE Dividends +/- Issues/Buying back assets = Net variation of cash Calculation of the available cash-flow; Source: accommodated taking-over from Fabozzi (2010). The estimation for FCFF and FCFE can be achieved through two methods. The first one presumes the calculation of the historical cash-flow followed by the application of an increase rate under the hypothesis of a constant increase and the maintaining of the fundamental factors of influence. This method is very similar to the Gordon model based on the up-dating of the future dividends; however, we should note that the increase rates for FCFE and FCFF are different. The second method consists of predicting the component elements of FCFF/FCFE and the individual calculation for each period of prediction. As shown by Fabozzi (2010), this method is more realistic, more flexible and, meantime, more complicated since it assumes that each component of the available cash-flow increases at a different rate on a specific time horizon. This method is frequently connecting the predictions with future capital expenses, the depreciation expenses and the variations of the working capital. Meanwhile, it is important to mention the fact that the investment with fix assets implies two dimensions: a component aiming to maintain the existing capacity and a second one meant to sustain the increase. Thus, the first component is linked with the current level of sales while the second one depends on the predicted increase of the sales. When estimating the FCFE by utilizing the second method, a a common assumption is that the company should maintain a constant degree of getting into debts for new investments in fix assets and working capital. In this case, the FCFE can be predicted with the support of the following formula: FCFE = [NI (1-DAR)x (FCI - DEP)]- [ (1 - DAR)x WCl], where: DAR = getting into debts degree DEP = depreciation expenses Now, we undertake to set up the evaluating formulas of the FCFF/FCFE models, starting from certain hypothesis regarding the stages of the increase of the company cashflow. In this respect, we shall consider two particular situations: first of all, the situation when the cash-flow is expected to increase at a constant rate over an undetermined period and, secondly, the situation when we have two or more stages of increase. 2. FCFF/FCFE models with a single stage of increase The FCFF model with a single stage of increase is analogous to the Gordon model of increase cu o utilized for evaluating the assets on the basis of the future flows of anticipated dividends. This model is useful for the analysis of the mature companies of the developed economies. The basic hypotheses of the model are the following: 83

- the available cash-flow will increase at a constant rate g every year; - the increase rate g is lower than the average weighted cost of the capital; The evaluating formula is: which, after processing, leads to:, where FCFFo is the value of the company available cash-flow due to the previous exercise. Acknowledging the fact that the sum from the above relation is a geometrical progression, we can write: The condition g < WACC is compulsory as, otherwise, the sum of the right member of the relation would be divergent. The actual calculation of the sum leads to:, which equals to: Where from, considering the fact that the limit is zero (g < WACC), we deduce immediately the evaluating formula for the FCFF model with a single stage of increase: WACC represents the weighted average of the profitableness rates requested by the company capital suppliers (creditors and shareholders), the weights being represented by the relative market values of the two financing sources: WACC = we x RE + (l - t)x wd x RD, where we and wd are representing weights of the two financing sources while Rd is the cost of the company debts (the yield at maturity of the issued bonds, in the case of the obligating bonds. When evaluating the average weighted cost of the capital, the assumption that the payments done by the company in favor of the shareholders are not deductible while the payments in favor of the creditors are deductible is an implicit one. Thus, the cost of running into debts considered for the setting up of the WACC is a net one, without the taxation policy impact. Of course, the average weighted cost of the capital is going to 84

modify to the extent the company capital structure modifies in time. This is why the specialists recommend the utilization of the target-structure of the company capital when setting up the WACC, instead of the weights resulting on the basis of the market values of the company own capitals and debts. However, we underline the fact that, in practice, quite frequently, the present structure of the company capitals differs from the optimal structure (the target-structure), as a result, for instance, of the management intention to speculate certain profitable opportunities on the market (for example, an unexpected decline of the interest rates, which implies the reduction in price for the company financing by means of borrowed capitals). The FCFE with a single stage of increase is analogous to the previous FCFF model, the evaluating formula for the company own capitals being the following: With the remark that g represents now the expected rate of increase for the cashflow available for distribution to the shareholders. As already discussed, this rate of increase is, of course, different from the rate of increase of the company available cashflow. The FCFE model with a single stage of increase is frequently utilized for the evaluation of the foreign companies with the purpose of merging and acquisition operations, mainly in the case of the companies originating in countries with high inflationist expectations, when the estimates for the nominal rates of increase and for the expected yields in nominal terms are hardly achievable, as shown by Fabozzi (2010). Before proceeding further, we reiterate the fact that the models consider a constant rate of increase for the company available cash-flows. 3. FCFF/FCFE models with several stages of increase The evaluating models based on the discounted available cash-flows, taking into account several stages of increase, are grounded on different projections (scenarios) concerning the pattern of the company cash-flow increase. Fabozzi (2010) explains the fact that a model with two stages can be utilized the evaluated company is recording a rapid increase (supernormal) on short-term basis and a stable increase on long-term basis. For instance, a company holding a patent that expires in seven years might have available cashflows increasing rapidly during the first seven years followed by an immediate diminution of the increasing rate down to its value on long-term basis, at the beginning of the eighth year. Fabozzi (2010) recommend also a model with three stages of increase when the company business prospects in the future indicate a period of increase, a stable period, corresponding to the maturity followed by a period of transition. The most popular (and the simplest) evaluating model with two stages of increase is that one where FCFF/FCFE are increasing at a high rate (and constantly) and then, decrease suddenly to the level of the increasing rate (again a constant one) on long-term basis. In this increasing scenario, the evaluating formula for FCFF is the following: where Nst represents the number of the years of quick increase. 85

The most efficient (and realistic) evaluating models with two stages of increase are represented by the so-called H models, which start from the hypothesis of a rapid increase during the first years but which diminishes gradually up to the constant value of the increasing rate of the long-term available cash-flows. The evaluating models based on FCFF/FCFE with several stages of increase can be approached either starting from the general evaluating model, or from sub-dividing them into more models with one/two stages of increase, as indicated by Fabozzi. Beyond the evaluating models based on FCFF or FCFE themselves, a significant role is played by the sensitiveness analysis, which shows the extent to which the value generated by the model is modified against the variation of the utilized inputs. Of course, is it reasonable to expect some variables to have a stronger impact on the evaluation results as comparatively with others but the sensitiveness analysis is the one allowing us just the quantification of this impact. As shown by Fabozzi, the main sources of errors in the process of evaluating on the basis of the available cash-flows are the following: - the estimation of the FCFF and FCFE future increase. The estimated rates of increase depend on the future efficiency of the company which, at its turn, depends on the increase of the sales volume, the profit margin, its position within the business cycle, its competitive strategy and, of course, on the general degree of profitableness of the industry where the company operates; - the selection of the base years for the predictions of the FCFF and FCFE increase rates. It is necessary to select a representative year as base year; otherwise all the subsequent evaluations might lead to non-conclusive outcomes; Under these circumstances, the sensitiveness analysis allows us to estimate an availability (corresponding to specific hypotheses concerning the influence factors of the inputs), which allows us to get an overall image of the evaluated company and, of course, a better understanding of the value influence factors. References [1]. Anghelache, G.V., (2004) Piaţa de capital. Caracteristici.Evoluţii.Tranziţii, Editura Economică [2]. Copeland, T; Weston, F. (2004) Financial Theory and Corporate Policy, 4 th edition, Addison-Wesley Publishing Company; [3]. Fama, E.F. (1976) Foundations of Finance, New York; [4]. Miskin, F. (2009) The economics of money, banking and financial markets, 9 th edition, Pearson [5]. Mossin, J. (1966) Equilibrium in a Capital Asset Market, Econometrica Vol. 34, No. 4, 768-783. [6]. Singer, B.D., Terhaar, K.(1997) Economic Foundations of Capital Market Returns Research Foundation of The Insitute of Chrtered Financial Analysts) 86