The discounted cash flow valuation approach postulates that the value of an asset is the present value of all cash flows expected from the asset during the asset’s entire life (Ehrhardt & Brigham, 2013). Therefore, the value of a firm can be determined by calculating the present value of its free cash flows. Free cash flow is the value of cash a firm generates after setting aside funds required to either to expand and maintain its current asset base. Free cash flow is used in the valuation since it represents the amount of cash the company has to pursue opportunities such as product improvement, repaying debt as well as developing new products, among others (Ehrhardt & Brigham, 2013). A positive and growing free cash flow is essential for the sustainability of the growth of earnings. This paper uses free cash flows to determine the value of the firm.
Free cash flows for 2014
Free cash flow = EBIT (1 – tax rate) + Depreciation & Amortization – Change in NCW – Capital expenditures
EBIT = $502,640
Tax rate = 40%
Depreciation for 2014 = $120,000
Change/investment in net working capital
This is determined by calculating the difference between working capitals for 2013 and 2014. Working capital is the difference between the value of current assets and current liabilities. An increase in working capital implies that the firm has invested in working capital thus reducing free cash flow (Ehrhardt & Brigham, 2013).
Net working capital for 2013 = Current assets excluding short-term investments – current liabilities (excluding notes payable)
= (1,946,802 – 20,000) – (1,328,960 – 720,000)
Net operating capital for 2014 = (2,680,112 – 71,632) – (1,039,800 – 300,000)
Change in net operating capital = 2014 working capital – 2013 working capital
= 1,868,680 - 1,317,842
In the above calculations, short-investments are excluded in the total value of current assets since short-term investment are not operating capital. Similarly, notes payable are excluded in the amount of total current liabilities since they do not affect operating capital.
These refer to the firm’s investment in long-term assets (Ehrhardt & Brigham, 2013). It can be determined by finding the change in the value of fixed assets between 2013 and 2014 and adjusting for depreciation. A positive capital expenditure reduces free cash flows.
Fixed assets for 2014 = Fixed assets for 2013 + Capital expenditure – Depreciation
Therefore, Capital expenditure = Net fixed assets for 2014 – Net Fixed assets for 2013
= 836,840 – 939,790
FCF2014 = 502,640 (1 – 0.4) - 550,838 – (-$102,950)
= 301,584 – 550,838 + 102,950
The above figure indicates that the firm had a negative cash flow in 2014 implying that its investments in working capital and capital expenditures were more than its cash flows from operations. In 2014, the company increased its investment in net working capital by $1,022,470 leading to a fall in its free cash flows. It also spent funds on acquiring fixed assets as shown by the positive value of its capital expenditure.
The negative free cash flow of 2015
A negative free cash flow shows that the firm’s investment in working capital and long-term assets was more than its operating cash flows (Ehrhardt & Brigham, 2013). A firm with a negative FCF is not necessarily in a financial trouble. It could imply that the firm is a growing or a young firm hence the owners are investing heavily in long-term assets that will enhance future earnings. Thus, the company operates with a negative free cash flow for a while until when the benefits of the investments start accruing. After some time, the firm generates much cash flows from the earlier investment hence it will have positive free cash flows (Ehrhardt & Brigham, 2013). Besides, the owners of the company may have decided to take on debt to firm its long-term investments. The company operates for some time with negative free cash flows but starts enjoying positive free cash flows when the benefits from such expansion projects start accruing.
The value of the firm is determined by discounting the firm’s free cash flows. ‘
Horizon value = FCF for 2019(WACC-growth rate)
PV of cash flows/Value of the firm
(-1,463,040*1) + (-963,040*1.1-1) + (500,000*1.1-2) + (1,000,000*1.1-3) + (4,650,000*1.1-4)
= -1,463,040 + -875,491 + 413,223 + 751,315 + 3,176,013
Value of equity = Value of the firm – Value of debt
= 2,002,020 – 1,539,800
Value per share = 462,220250,000 = $1.85
The free cash flows above are discounted to determine the value of the enterprise. The growth rate in free cash flows is assumed to be constant at 5% from the year 2018. Therefore, free cash flows will be a growing perpetuity from 2018.
As shown above, the value of the firm is $2,002,020 and the value of the firm’s equity is $462,220 implying that the value per share is $1.85. The firm’s stock is trading at $12.17 implying that it is overvalued since the intrinsic value is less than the market value. An overvalued stock is not a good buy since the price is likely to fall in future to reflect the intrinsic value of the stock (Ehrhardt & Brigham, 2013). However, the stocks of companies with high growth potential may be selling at higher prices due to the high earnings expected in future.
The firm had a negative free cash flow in 2014 as shown above. The negative free cash flow is attributed to large investments in working capital and long-term assets. A negative free cash flow is not a bad condition and may indicate that the company is investing for future earnings. A free cash flow valuation of the company indicates that its enterprise value per share is less than the market price of the share implying that the stock is overvalued.
Ehrhardt, M., & Brigham, E. (2013). Corporate Finance: A Focused Approach. New York: Cengage Learning.