INVESTMENT TOOLS

Valuation Equity Valuation

Free Cash Flows

I
G Kumaraswamy Naidu Consulting Editor, Portfolio Organizer. Manoj Gautam Research Associate, Examinations Department, The ICFAI University. Sanchita Patnaik Research Associate, Examinations Department, The ICFAI University.

The application of free cash flow models is thought of as the most challenging and enriching exercise for analysts involved in equity valuation.

n our previous article, Equity Valuation: Dividend Discount Model, published in Portfolio Organizer, May 2005, we learnt the practical application of Dividend Discount Model (DDM) of valuation. There are many shortcomings in DDM. It cannot be used to value companies which do not pay dividends. Also, the earnings of the companies must exhibit a significant relationship with the dividends. Due to these reasons, analysts began focusing on alternate measures of value. The free cash flow valuation came in vogue in the 1980s but till very recently, analysts used to have a fascination for earnings. Companies were also doing their bit by focusing on short-term earnings to make up good numbers for quarterly analysts meets. Several accounting scandals followed by the collapse of some of the major firms like Enron and WorldCom changed this scenario. Analysts and academicians began to understand the importance of cash flows. Cash flows, rather than earnings, as indicators of the future market price may look absurd to staunch supporters of earnings; but earnings are affected by diverse accounting policies adopted by various firms while cash flows reduce this variability. Market experiences have established that current stock prices are more influenced by long-term cash flows than by short-term earnings numbers. Not long ago, Indian banks were making huge provisions NPAs and writing them off. Going by the earnings logic, share prices should have tumbled, but in most cases, the reverse happened as the market viewed this as an indicator of healthy cash flows in future. According to Rappaport and Mouboussim, 2001, the discounted cash flow model is the only theoretically correct valuation model that can explain the pricing of equity stock.

Free Cash Flows

Free cash flows are the cash flows available to the suppliers of capital to the firm after meeting all the cash expenses and necessary investment needs. These are also called discretionary cash flows or operating cash flows. These are the true operating cash flows of the firm (Tim Copelland, et al). Free cash flows can further be segregated into Free Cash Flows to Firm (FCFF) and

2005 The ICFAI University Press. All Rights Reserved. 49

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Free Cash Flows to Equity (FCFE). FCFF are computed before taking financial charges into consideration, as these are the cash flows available to all the suppliers of capital. Suppliers of capital include debt holders, equity shareholders and preferred shareholders. The choice between FCFF and FCFE depends upon the leverage factor. Generally, when firms have a stable capital structure and are expected to continue with this in foreseeable future, FCFE is used as the leverage needs of the firms can be easily predicted and can be factored in. However, in real life, the capital structure of firms is volatile depending upon business conditions and their reinvestment needs. In such cases, FCFF can give a good measure of value, as it is a pre-debt cash flow. Values obtained under both the approaches will be equal if the leverage ratio is insignificant. Contrary to common perception, FCF are different from operating cash flows reported in the financial statements, as we will see later. Since the growth of firms assumes different stages depending on their life cycle, analysts use N-stage models to find out the value of the firm. It is similar to DDM in many respects. We have discussed single stage, 2-stage and 3-stage DDMs. Let us discuss the application of these stages to the FCF model.

Free cash flows Model

There are different stages models which analysts use. First is Single stage model. Mathematically, Single stage model can be represented as follows:
FCF 1 k g

Present value of free cash flows = Where FCF k g = = =

Free cash flows of the firm Discount rate Likely growth rate in free cash flows of the firm in next period

This model is suited to value firms, which are expected to grow at stable growth rate in perpetuity. The problem with this model lies in the denominator. If k in the above equation is less than the growth rate, then this model becomes worthless. Generally n stage model is used to value firms. As in dividends discount model, we can use H-model, 2 and 3 stage model in FCF valuation. Dividends are substituted by FCF here. The n-stage model can be represented as follows:

FCF t Value of the firm = t = 1 (1 + k )t

We have used the term FCF i.e. free cash flows, which can be either FCFF or FCFE. As FCFF indicates the total value of the operating assets of the firm including the value of debt, if we use FCFF to find the value of the firm then we need to deduct the market

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INVESTMENT TOOLS
value of debt from the cumulated present value. After arriving at the value of operating assets, we add the value of non-operating assets like investments to find the value of equity

Deriving Free Cash Flows

Free cash flow to firm can be derived from net income as follows: Net income (as reported) Plus Net non-cash charges Plus Interest expense (1-t) Less Gross investment in fixed assets Less Investment in working capital Forecasting FCFF is quite a challenging and enriching exercise for analysts and requires a complete understanding of the financial statements of the company. As we see in the equation, the starting point for the calculation of FCFF is the net income as reported in the financial statements of the company. Net income as reported is after deducting depreciation, financial charges, income tax and amortizations. If firms have preferred share capital, then preferred dividends are also deducted. In order to give our readers a comprehensive view of FCFF, we will discuss the segments of FCFF one by one.

Net Non-cash Charges

A company incurs some non-cash expenses in the course of While valuing new business such as depreciation and amortizations. No cash economy outflow occurs in the case of such expenses. Since we try to companies, stock find out the cash flows of the firm, these expenses are to be added back to the net income. To ensure consistency in our options are also calculations, non-cash income is also not considered. This is found in the why we prefer to call this segment net non-cash charges. balance sheets of Depreciation is one major non-cash item. It results out of the use of assets to generate income. It is recorded in the few companies books of the company but it is merely a book entry and no cash outflow occurs. Similarly, in case of patents and intangibles, the company incurs cash expenses in one period and then it allocates these expenses over a period of time. These also have to be amortized over a period of time. These amortizations are also to be added back. There are some more items like gains or losses on sale of investments and restructuring charges which are to be adjusted accordingly. Apart from this, deferred taxes warrant special attention. Sometimes there is a vast difference between cash taxes paid by the firm and taxes considered while arriving at the net income. Sometimes companies deduct expenses like penalties paid for late payment of taxes, etc. which are not tax-allowed u/s 37 of the Income Tax Act, 1961. This lead to the understatement of tax reported in the financial statements in comparison to actual tax payments. Sometimes the company may have the ability to defer taxes till a long period. In such a case, the reported tax has to be added back to the net income. While valuing new economy companies, stock options are also found in the balance sheets of few companies. Although these represent expenses from an accounting point of view and are recorded under the expenditure head, no cash outflow is involved. But at the time of exercise by employees, companies receive cash. These factors are to be considered while calculating cash flows.
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Interest Expense
While arriving at the net income, interest expenses are deducted from total income. Since our aim is to find out the cash flows available to all the suppliers of the capital, interest expenses are to be added back. The long-term creditors of the company are interested in the cash flows that are available for servicing their debt. Since interest has a tax-shield associated with it, tax adjustments are done prior to its inclusion.

Gross Investment in Fixed Assets

A company, in order to grow continuously, invests in new assets and retires some of the existing assets. These investments are integral to the successful running of the business. While valuing firms, estimation of expenditure on fixed assets pose a significant challenge because generally companies do not have a smooth capital investment stream. Specifically, Indian companies often follow random capital investment policies. Hence, it becomes an arduous task to estimate precise capital investments over a period of time.

Changes in Net Working Capital

A firm needs to invest some part of its cash in its working capital in order to ensure smooth functioning of its day-to-day functions. Working capital usually implies the difference between the current assets and current liabilities. Current assets comprise inventories, debtors and cash balances. While arriving at the figure for current assets, we generally exclude cash and cash equivalents as valuation is a forward-looking exercise and change in working capital reflects the funds accrued but cash has already been generated. Cash investments by firms generally earn them There are a return, unlike other current assets. Some analysts feel conflicting views that firms generally maintain cash that is in excess of their and in practice, working capital requirements. So instead of excluding entire cash balances, only that cash which is in excess of their analysts often working capital requirements should be excluded. There are segregate cash conflicting views and in practice, analysts often segregate flows into required cash flows into required and excess. We have excluded cash altogether from our calculations of working capital. Coming and excess to current liabilities, these include creditors and accrued expenses. We only consider non-interest bearing liabilities. Current portion of long-term debt and all interest bearing liabilities are excluded as we are concerned with operating items, and interest expense is added back to net income while calculating FCFF. While doing valuation, consistency between the different parameters has to be maintained. After arriving at FCFF from net income, we forecast these FCFF over a period and then we proceed to find the present value of FCFF using the appropriate discount rate. The mathematical formula is as follows: Firm value =

FCFF

t = 1 (1 + WACC )t

WACC stands for weighted average cost of capital. It represents opportunity cost of capital to the investors investing in the firm. Weighted average of all the sources of capital is taken. The formula for WACC is as follows:
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WACC = kd(1- t) x D/V + ke x E/V + kp x P/V Where: kd = Pre-tax cost of debt ke= Cost of equity kp= Cost of preference capital D = Market value of debt E = Market value of equity P = Market value of preference capital t = Marginal tax rate V = Market value of the firm

We use market value weights as market value represents the true value of claims by various providers of capital.

Debt
Where debt is not traded in the secondary market, traded debt securities of a similar nature in terms of tenure and credit quality are searched. Using their yield to maturity as discount rate, present value is calculated. This present value is used as market value of debt. While estimating cost While estimating of debt, the coupon interest should never be taken as it is static and does not portray a true picture of the current cost of debt, the conditions. Another approach pertains to the use of risk free coupon interest rate. We dealt with risk-free rate in our previous article. should never be Default risk of the entity is found by assessing its rating and if no ratings are available, then analysts estimate effective taken as it is static proxies for these ratings by using their own methods. After and does not that, the rating spread is added to the risk-free rate. After portray a true calculating the cost of debt, we calculate the market value of picture of the debt using the cost to discount the cash flows associated with the debt. current conditions Coming back to the cost of debt, as it is tax-deductible, it is multiplied by the tax adjustment factor, i.e., (1-t) where t is marginal tax rate, to arrive at post tax cost of debt.

Equity
Equity is traded in the market so that the number of outstanding shares is multiplied by the current market price to obtain the market value. Cost of equity is already dealt with in detail in our previous article. (Valuation of Equity: Dividend Discount Model in Portfolio Organizer, May 2005).

Preferred Securities
Preferred stocks pay dividends perpetually to the preferred shareholders. Their cost can be found by dividing the dividends by their market price.

Expected Growth Rate

Another very important issue pertaining to the FCFF model is its expected growth rate. The assumption underlying the firms value undergoes key changes depending upon the growth of the firms. When firms are relatively new, their reinvestment needs are substantial. Capital spending is much more than depreciation. However, when firms approach the maturity stage, their reinvestment needs are curtailed and the difference between capital expenditure and depreciation becomes smaller. Many analysts assume that during stable growth period capital spending offsets depreciation.
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This issue was also dealt in detail in our previous article. Expected growth of the firm depends upon their competitive advantage. There are some fundamental determinants of growth in EPS like ROE and retention ratio. However, analysts perception of the likely growth of the firm plays an important part in assigning growth for the firm.

Terminal Value
The calculation of terminal value under this model more or less remains the same as DDM. The dividends are replaced by FCF. At the beginning of the stable period, the terminal value is calculated assuming that FCF would grow at a stable rate forever. Terminal value = FCF/ k-g Where FCF can be FCFE or FCFF depending upon the cash flows we are using for valuation. k = Discount rate g = Growth rate in the stable period While calculating terminal value, the assumptions regarding key parameters like capital spending, depreciation, cost of equity and cost of debt change. In the matured stage, due to lack of reinvestment opportunities, the capital spending becomes less. The cost of equity, if we use CAPM to calculate it, also changes, as beta in stable phase is different from beta in high growth period. After calculating the present value of FCFF, we deduct market value of debt outstanding to arrive at the value of operating assets of the firm.

Free Cash Flow to Equity (FCFE)

Free cash flows to equity are the cash flows that are available to equity holders after satisfying claims of all other providers of capital. Equity shareholders bear the ultimate risk of running the business and they are the last ones to be paid in the event of liquidation of the firm. Hence, FCFF are reduced after tax financing charges. Since companies continually resort to debt financing and pay a part of their debt, net borrowings are added to FCFF in order to estimate the cash flows available to the equity shareholders. The relationship between FCFF and FCFE can be represented as follows: FCFE = FCFF interest (1-t) + Net borrowings Where net borrowings = Borrowings in new debt repayment of old debt. The FCFE can be calculated from the net income as follows: Net income (as reported) Plus Net non-cash charges Less Gross investment in fixed assets Less Investment in working capital Plus Net borrowings Since FCFE are cash flows to equity holders, these are discounted using cost of equity as discount rate.

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Theoretically, FCFE should be equal to the dividends as these are the actual cash flows that are available to the equity shareholders. In practice, firms do pay less than this amount due to varied reasons. One of the reasons which could be cited is the companys preference to adopt stable payout policy over a period of time. These are standard definitions of FCFE and FCFF from net income as reported by the firms. However, in practice, analysts use varied methods to derive these cash flows. Many analysts, instead of using the bottom up approach, i.e., net income approach, start with EBITDA. However, in all these approaches, the basic tenet remains the same.

Value of Non-operating Assets

While calculating FCFE and FCFF, we exclude excess cash and other non-operating assets from calculation. About their treatment, the analysts are divided. A section feels that these are non-operating and hence should be excluded from calculations. However, we feel that sometimes companies have enormous amounts tied up in cash and they also invest heavily in marketable securities. Hence, it would be inappropriate to exclude these from calculations. This also ensures consistency since net income includes other income. If we include these in our calculations, then another problem arises regarding discounting them. WACC cannot be used, as it does not reflect the true cost of holding these assets. Many analysts commit the mistake of lumping these with operating assets and then they try to find out the value. However, we advocate taking them separately. Excess cash can be taken at book value since market vale of cash is equal to its book value. Marketable securities can be valued using their current market value. However, this is a conservative approach, as many firms tend to invest heavily in undervalued security. Still, this approach seems better than applying discretionary premium to their value, which is subject to manipulation. The value of equity then becomes: Value = Value of operating assets + Excess Cash + MV of non-operating assets

Suitability of the Model

FCF models score where DDM fails. These models are basically used to value companies which either are non-dividend paying or pay significantly lesser dividends then they can afford to pay. Also, cash flows of the firms should exhibit significant relationship with the earnings of the company. These models can also be used from control perspective. If investors want to value a firm to eventually take it over than DDM cannot be used as dividends are board decisions and can be influenced by the investor once he gains control over the firm.

FCF Valuation: A Practical Illustration

After analyzing various companies, we zeroed in on Motor Industries Company Limited (MICO). The Company is into the auto-ancillary sector and a subsidiary of Robert Bosch AG (Germany). The company is a key market player in the auto-ancillary sector. It holds virtual monopoly in some of the key components like manufacturing of spark plugs and fuel injection system. For the year 2004, it has shown a strong earnings growth of around 60%. A fresh injection of capital by the parent company is all set to provide MICO a platform to launch itself aggressively into the growing international market. We believe that MICO is an ideal candidate for the FCF valuation due to following factors: The company has been following a policy of low dividend payout as evident from Table 1. The dividends payout ratio has been hovering around 9%. The dividend paying capacity of the firm is quite high as can be gauged from the proportion of cash in total

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current assets. The debt Table 1: MICO Relevant Ratios equity ratio of the firm is 2001 2002 2003 2004 quite stable at 0.1 for past few Debt/equity ratio 0.1 0.1 0.1 0.l (E) years. These make MICO an Dividends payout ratio 10% 9% 6% 8% ideal company for valuation Cash/Total assets ratio 20.47% 42.94% 48.29% 43.19% (E) under FCFF model. Industry Overview: Despite facing some jitters in the past, the auto-ancillary sector is back in focus due to easing of the steel commodity cycle. The $7 bn domestic industry is on the threshold of a new revolution in the near future. The industry can be divided into two segmentsOriginal Equipment Manufacture (OEM) and after market sales. Demand from OEMs has been growing at a rapid rate, as most of the OEMs prefer to outsource their requirements due to margin pressures and subsequent efforts to cost cutting in order to remain viable in the highly competitive auto industry. OEMs account for nearly 75% of the sales of the sector. With the domestic auto industry growing at a healthy pace, the domestic demand for auto-parts is likely to be healthy in the near future. The auto-ancillary sector can be segmented into organized and unorganized segments. It is highly fragmented. The unorganized sector contributes nearly 78% to the total market and consists of around 400 players. Many fake products from this segment flow to the market causing the companies considerable trouble. A report by AT Kearney has slated the future growth of auto component industry to be at a CAGR of 15% till year 2012. The global auto industry is worth $1000 bn. It is facing enormous cost pressure due to the industry being highly competitive. The margins are under pressure. This has made international players look towards low-cost manufacturing countries like India for outsourcing. The Indian industry is realizing the potential of exports as India as an outsourcing hub is better placed than most of its Asian neighbors due to it being superior in engineering designs and availability of quality manpower at a bargain price. It also scores over other non-outsourcing hubs like Mexico, Europe and Brazil due to low cost of manufacturing of auto-parts. With outsourcing expected to gain momentum this fiscal, the industry is going to take off in a big way. This is particularly helped by the fact that India is among one of the lowest cost manufacturer of aluminum (a key raw material for auto manufacturing) and steel. The margins of companies are also expected to improve due to recent news about easing of steel prices. Valuation of MICO: We divided the growth of the company into three distinct phases, i.e., high growth period followed by transition period followed by stable growth period, starting from the year 2005. MICO is commissioning the production of the Common Rail Diesel Injection (CRDi) system in India in 2005. The product will enter the market in 2006. Considering the huge potential in India with respect to this product, the sales of MICO are expected to show a significant increase in 2006. Exports of the company are also expected to increase in line with the parent companys plan to increase outsourcing from India. High Growth Period: Auto-ancillary sales are expected to rise in the near-term due to spurt in auto sales and global outsourcing. Nearly all segments of the auto industry have been showing an upward trend. Although there was a brief lull last year, that did not stop FIIs from investing in the sector heavily. Domestic sales of the auto-ancillary sector are heavily dependent on the sales of the auto sector. MICO enjoys a virtual monopoly in two of its flagship products, namely spark plugs and fuel injection system. It controls nearly 65% in the former category while in the latter, it controls nearly 80%

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of the industry sales. These contribute nearly 38% and 2.87% to the total revenues of the company. Another significant item is nozzles, which contributes 22% to the total revenues of the company. In the spark plug and nozzle segment, the company might face some problems, as pressure is two-pronged. First, the threat is from the oversupply of cheap products from the unorganized sector. The second threat is related to the availability of cheap substitutes from China and Thailand. We expect the sales of MICO to increase by 20% in the year 2005. The Company recorded an impressive growth of 60% in earnings for 2004. This was due to fresh demand for their fuel injector system. The Operating Profit Margin (OPM) of the company is already 27% and we do not foresee any significant increase in the OPM. MICO is introducing the CRDi system in India from 2006; this product can help the company reach new high of sales in the coming year. The pricing power of the product is not known. However, considering the immense potential of the product, we believe sales of the company will show at least 70% rise in 2006. Many analysts are of the opinion that We expect the sales will double in 2006, but many foreign carmakers have sales of MICO to ambitious plans to enter the country with cars that are already equipped with the CRDi system. Hence, we are increase by 20% in taking a very conservative view. Considering the plans of the year 2005. The some players to make an aggressive entry into the segment, Company recorded the sales from this segment will eventually slow down. The an impressive sales are expected to increase by 40% for the year 2007 and 30% for the year 2008. growth of 60% in We prepared a proforma income statement for this high growth period from 2005 to 2008. We forecast the individual components of income statement taking the most recent percentage to sales as MICO achieved significant cost efficiency during 2004.

earnings for 2004

Cost of Capital: The cost of equity is calculated using CAPM. The beta value of MICO was calculated by regressing the returns of the stock of the company with the S&P 500 index. It was around 0.44. The risk free rate is taken at 6.5% while the market risk premium is taken at 7.5%. (Please refer to Valuation of Equity: Dividend Discount Model in Portfolio Organizer, May 2005). The cost of equity has been calculated as follows: 6.5% + 0.44(7.5) = 9.8%. We assumed a target debt equity ratio of 10% considering the historical ratio. The value of debt was found by adjusting the value of equity at the year-end for the net profits after the dividends. We assumed the dividend payout ratio of 8% again considering the historical record of the company. An effective interest rate of 5.13% was used to calculate the cost of capital. The cost of capital was to 9.22%. After forecasting these amounts, the projected FCFF statement of MICO was prepared. (See Table 2). Transition Period: The high growth period will last for 4 years. After the high growth period, the transition period will begin at the end of which the earnings of the company will settle to a stable growth rate. We assume this period to last for 5 years. Entry of new players in the fray coupled with the expected slowdown in the auto sector can play spoilsport. Instead of focusing on individual components for this period, we focused on the likely growth in FCFF that the company is expected to have. As explained in the previous article, the stable growth rate of the firms is more or less equal to the long-term growth rate of the economy in which it operates. Growth of the auto-ancillary sector is linked
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Table 2: Performa Statement during High Growth Period
Rs. in millions Year Sales Other Income Total Income Expenditure Change in stock Raw material Staff cost Other expenditure Total Expenditure PBDIT Interest1 PBDT Depreciation2 PBT TAX @35%3 PAT Plus: Depreciation Minus: Changes in working capital4 Plus: Interest (1-t) Minus changes in Fixed assets5 FCFF PV @9.2% 2005 27,934.80 927.28 28,862.10 +1,396.74 11,173.90 4,190.22 5,586.96 19,554.40 9,307.72 64.32 9,243.40 1,729.30 7,514.10 2,629.94 4,884.17 1,729.30 150.053 41.808 5,500.00 1,005.22 920.36 2006 47,489.20 967.59 48,456.80 +2,374.46 18,995.70 7,123.37 9,497.83 33,242.40 15,214.40 87.38 15,127.00 1,856.95 13,270.00 4,644.51 8,625.51 1,856.95 631.60 56.797 1,500.00 8,407.66 7,048.08 2007 66,484.80 1,009.00 67,493.80 +3,324.24 26,594.00 9,972.72 13,297.00 46,539.40 20,954.40 128.08 20,826.30 1,984.60 18,841.70 6,594.60 12,247.10 1,984.60 613.57 83.252 1,500.00 12,201.40 9,364.59 2008 86,430.30 1,052.19 87,482.50 +4,322.00 34,572.10 12,964.50 17,286.10 60,500.70 26,981.80 190.91 26,790.90 2,109.78 24,681.10 8,638.38 16,042.70 2,109.78 644.23 124.092 1,500.00 16,132.30 11,336.70

1. Interest: For the past few years, the company has been following a policy of keeping a stable D/E ratio of 10%. We continue with this ratio to arrive at the debt amount for the company. A lot of debt of the company is in the form of short-term credit, like sales-tax deferrals. Hence, the cost of debt for the company is arrived at 5.13%. 2. Depreciation: In absence of specific information about the depreciation policy of the company, we took past average of depreciation figures as a percentage to gross fixed assets. It was around 8.23%. 3. Tax rate: The marginal tax rate of 35% is taken into account. 4. Changes in non-cash working capital: We took the average percentage of working capital to sales to arrive at this figure. Working capital investments are highly correlated with the sales in general. Then we deduct the previous years figure from the current year figure to arrive at the changes. 5. Investments in fixed assets: According to company sources, the parent company has huge plans for MICO. The parent company is going to invest Rs. 1000 cr over a period of 4 years in the company. Rs. 550 cr will be invested in the year 2005 to start the commissioning process of CRDi systems while rest, Rs. 450 cr, will be invested in three installments, in the years 2006, 2007 and 2008.

closely to the growth of the GDP of the country. We have used the sustainable growth rate method to calculate the stable growth rate of the company. The long-term ROE of the company is approximately 20%. We have assumed that MICO will pay 50% of its earnings as dividends in the stable period. Therefore, the stable growth rate is taken at 10%. This is lower than the long-term growth forecast for the economy at 12%. The growth in FCFF for the year 2008 was 32.16%. This will decline linearly to 10% at the end of 2013. As we have assumed that the beta of the company will be 1 in the stable phase, we have linearly increased this beta from 0.44 in the year 2008 to 1 in the year 2013. Hence, cost of capital also changes during the transition phase. Terminal Value: By making use of expected FCFF during 2013, we calculated the terminal value at the end of 2013 as follows:

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Terminal value = FCFF2012 (1+ growth rate
stable period

) / (WACC

stable phase

stable phase

In the stable phase, the cost of capital changes significantly. We adopted the custom of using beta 1 in the stable phase as in the stable phase the returns of the firms match with that on market and risk characteristics of the firms change significantly. We also consider the penchant of the parent company to keep its subsidiary debt-free in the stable phase. Hence, we assumed that in the stable phase, MICO would go debt-free. The cost of capital using the beta 1 and keeping other factors constant come to 14.0%. The total value of FCFF of the company stood at Rs. 414,065.04 mn. To arrive at the value of equity, MV of debt, i.e., Rs. 1,253.90 (calculated on our own since the final figures have not been available) is deducted. To this figure, we added the value of cash (we excluded cash from working capital calculations) and value of nonoperating assets to arrive at the total value of the firm.
Cashflows During Transition Period
Year 2009 2010 2011 2012 14.00 34,383.20 12.37 13,525.18 2013 10.00 37,821.05 14.00 11,630.27

Growth (%) 27.73 FCFF (Rs. mn) 20,605.80 Discounting factor (%) 10.07 Present value (PV) (Rs. mn) 12,753.95 Present value of Free Cash Flows during high growth period (Rs. mn) Present value of Free Cash Flows during Transition period (Rs. mn) PV of Terminal value (Rs. mn) Total

23.00 19.00 25,345.10 30,160.70 10.81 11.63 13,690.53 13,962.87

28,669.73

65,562.80 319,832.51 414,065.04

The total value of the firms equity = 414,065.04 1,253.90 + 4,891.14 + 2,915 = Rs.420,617 mn This figure, when divided by the total number of shares outstanding, i.e., 32.05 million gives us a figure of Rs. 13,123.78 per share. Ever since the world discovered the concept of FCF, it has been gaining ground. The real importance of FCF lies in its applications. Non-dividend firms can also be valued using FCF. However, there are significant practical problems also. FCF valuation, like other valuation models, depends on significant assumptions regarding growth rate, cost of capital, reinvestment opportunities and capital structure. The capital structure can change and so can the cost of capital for the company. The depreciation policy was not clear from the annual reports so we made our own assumptions, which we found were justified. We assumed the growth rate to decline linearly during the stable phase, which may not be the case. P

Reference # 6M-2005-06-10-01

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