📊 1. Forecasting Free Cash Flows (FCFF and FCFE)

🔹 A. What is Free Cash Flow?

Free cash flow (FCF) represents the cash a company generates after accounting for operating expenses and capital expenditures. It is used in DCF to measure the actual cash available for investors or the firm.

🔸 Free Cash Flow to the Firm (FCFF)

Used to value entire enterprise (debt + equity holders)

Formula:

FCFF=EBIT×(1−TaxRate)+Depreciation/Amortization−CapEx−ΔWorking Capitaltext{FCFF} = EBIT times (1 – Tax Rate) + text{Depreciation/Amortization} – text{CapEx} – Delta text{Working Capital}

Where:

  • EBIT = Earnings Before Interest and Taxes

  • CapEx = Capital Expenditures

  • Δ Working Capital = Change in current assets minus current liabilities (excluding cash and debt)

🔸 Free Cash Flow to Equity (FCFE)

Used to value equity holders only

Formula:

FCFE=Net Income+Depreciation−CapEx−ΔWorking Capital+Net Borrowingtext{FCFE} = text{Net Income} + text{Depreciation} – text{CapEx} – Delta text{Working Capital} + text{Net Borrowing}

🔹 Which to Use?

Situation Use FCFF Use FCFE
You’re valuing entire firm (EV) ✅ Yes ❌ No
You want to value equity directly ❌ No ✅ Yes
Capital structure is changing ✅ Preferred ❌ FCFE becomes complex

💰 2. Calculating WACC (Weighted Average Cost of Capital)

WACC is the discount rate used in FCFF-based DCF to reflect the cost of capital from both equity and debt.

🔹 Formula:

WACC=(ED+E)⋅re+(DD+E)⋅rd⋅(1−T)text{WACC} = left(frac{E}{D+E}right) cdot r_e + left(frac{D}{D+E}right) cdot r_d cdot (1 – T)

Where:

  • E = Market value of equity

  • D = Market value of debt

  • rₑ = Cost of equity

  • r_d = Cost of debt

  • T = Corporate tax rate

🔸 Calculating Cost of Equity (rₑ):

Use CAPM (Capital Asset Pricing Model):

re=Rf+β(Rm−Rf)r_e = R_f + beta (R_m – R_f)

Where:

  • R_f = Risk-free rate (e.g., 10-year government bond)

  • β = Beta of the stock (risk relative to market)

  • Rₘ – R_f = Market risk premium

🏁 3. Terminal Value Estimation

After a 5–10 year forecast period, a business is often assumed to grow at a stable rate.

🔹 Two Common Methods:

🔸 A. Gordon Growth Model (Perpetuity Growth)

TV=FCFn+1WACC−gtext{TV} = frac{FCF_{n+1}}{WACC – g}

Where:

  • FCFₙ₊₁ = Free cash flow in first year after forecast

  • g = Long-term growth rate (typically 2%–3%)

🔸 B. Exit Multiple Method

TV=EBITDAfinal year×Assumed Multipletext{TV} = text{EBITDA}_{text{final year}} times text{Assumed Multiple}

Example: 5× terminal EBITDA = Terminal Value

🧮 4. Present Value Calculation and Interpretation

Once all cash flows and terminal value are forecasted, they must be discounted to present value using the WACC.

🔹 DCF Formula:

Enterprise Value=∑t=1nFCFFt(1+WACC)t+TV(1+WACC)ntext{Enterprise Value} = sum_{t=1}^{n} frac{FCFF_t}{(1 + WACC)^t} + frac{TV}{(1 + WACC)^n}

🔹 Steps:

  1. Discount each year’s FCFF to present value

  2. Discount the terminal value

  3. Add together to get Enterprise Value

  4. Subtract Net Debt to get Equity Value

🧾 Example Summary

Let’s say:

  • FCFF over 5 years = $10M, $12M, $14M, $16M, $18M

  • Terminal Value (Gordon) = $200M

  • WACC = 10%

Then:

PV of FCFF=∑FCFFt(1+0.10)ttext{PV of FCFF} = sum frac{FCFF_t}{(1 + 0.10)^t} PV of Terminal Value=200M(1+0.10)5≈124.2Mtext{PV of Terminal Value} = frac{200M}{(1 + 0.10)^5} approx 124.2M

Add all PVs to get the Enterprise Value, then subtract debt to get the Equity Value.

✅ Final Summary Table

Element Purpose
FCFF/FCFE Measure available cash for valuation
WACC Discount rate reflecting risk
Terminal Value Estimate continuing value beyond forecast
NPV of cash flows + TV Final enterprise or equity valuation
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