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Free Cash Flow, Economic Value Added and Firm ValueGautam BhaumikGuest Lecturer in Commen:e,University of CalcuttaAbstractThis paper addresses the issue of value creating potential of the firm and its current and proposedendeavours along wilh their financial impacts. In this regard, two valuation proposed -Free Cash Flow(FCF) and Economic Value Added (EVA)-both of which are based on the notion of discounted cash flowconcept, are used as logical and appropriate criteria of value creation. In d1e course of the discussion theauthor defines FCF, presents the FCF melhod of val1iation, and describes the process of FCF forecasting.The paper also highlights the concept of EVA and its use in computing Ec0nomic Value (EV) of the finn.In conclusion, an effort is made to reconcile these two approaches to establish that firm vaJue is independentof these perspectives.Key-Words : Value Creation; Discounted Cash Flow; Free Cash Flow; Economic Value Added; EconomicValue.IntroductionIn recent times. capital as a factor of production has been gaining more prominence than everbecause of globalisation and movement of capital across countries. As a result, the needs ofsuppliers of capital (investors) become paramount. They are very much interested to know theunderlying value for making investment decisions. The value creating potential of the firm andits current and proposed endeavours along with their financial impacts are the most significantinformation they demand. Therefore, the question that comes uppermost is : on what basisvaluation of a firm should be done so as to reflect value creation perspective. As value creationis a continuous process and value of a firm is a mathematical function of amount, timing and riskinvolved in generating its future income stream, any valuation method that addresses thesecriteria of value creation should be considered to be appropriate and logical. In this article, twosuch valuation frameworks-Free Cash Flow (FCF) and Economic Value Added (EVA) methodof valui.tion - are presented.Both these valuation methods are based on the notion of Discounted Cash Flow (DCF) conceptand assume the perspective of firm's investors when deciding how best to run the business.Section two of the article defines FCF while section three presents the concept of FCF methodof valuation. Section four narrates the process of forecasing FCF, whereas section five describesthe concept of EVA and its use in computing Economic Value (EV) of the firm. In the lastsection, an effort is made to reconcile these two approaches so as to establish that firm value isindependent of these perspectives.

237FCF and ils ComputationIn defining FCF, we are interested in Investor's perspective. Therefore. the question is : what iscash flow at matters to the firm's investors. It is the cash that is free and available to providea return investor's capital. Technically, FCF is equal to after tax cash flows from operationless any incremental mvestments made in the finn's operating assets. Increase in incremental inv stment n operat ng assets may be calculated by adding the figure of increase in workingcapital and mcrease m fixed assets and other long term assets. An alternative and equivalentapproach of calculating such amount is increase in total assets minus the increase in non interestbearing current liabilities. A simple way of calculating FCF is shown below.Amount Rs.Net operating profit before taxAdd : Depreciation and AmortizationAdd/Less : Non cash items and extra ordinary itemsxxxxxxLess : Tax paidAfter tax cash flow from operationxxxxLess : Increase in net working capital, which iss equal to increase incurrent assets minus increase in non-interest bearing current liabilitiesLess : Increase in fixed assets and other long term assetsFree Cash Flow (FCF)xxxxxxTo summarize, a company's free cash flow is equal to the amount distributable to its investors.So, free cash flow is the result of firm's operating, investing and financial decisions.FCF Method of ValuationConstituents of cash flows and how these are distributed or applied while are essential informationin managing a firm, there is another reason for computing a firm's cash flows- to estimate firmvalue. If it is given that a firm generates a FCF of Rs. 8000 lakh in a year and if investors expectthe firm to generate this same level of cash flows every year in the future, then it definitelysuggests something about firm value. In the context ofDCF model of firm value. we could thinkof firm value as equal to the present value of the future cash flow stream. In other words, firmvalue is the present value of the future cash flow stream of Rs.8000 lakh, discounted at theinvestor's required rate of return.Free cash flow method is the most important and recognized method of valuing a firm. Thismethod is based on the notion of DCF concept of valuation and therefore considers the amount,timing and risk involved in generating future cash flow. It can be said that if cash is returned torhe business and ultimately to the investors then it would lead to value creation. This factpopularizes the cash flow basis of valuation. Another reason is that cash flow is a fact and notan opinion like profits and, as such, any valuation based on cash flow is logically superior.

238Finn's EV is equal to the present value of its future FCFs discounted at its cost of capital (KJplus the value of the finn's non-operating assets. Thus,Finn value Present value of all future FCFs Value of non-operating assetsThe concept of valuing a finn based on FCF does not appear to be difficult. But to estimate thevalue of a firm, we should at first project future FCFs. And projecting a finn 's FCFs for itsentire life is no easy task because of the degree of uncenainly involved. However, given thedifficulties with forescasting distant cash flow, a more sensible approach is to divide the finn'sflows into two parts :(1)cash flows to be received during a finite period that corresponds to the finn's strategicplanning period ;(2)cash flows to be received after the strategic planning period.The length of the planning period should be detennined by the duration of the competitive advantagethat the firm enjoys. When the competitive advantage has dissipated, there is no incentive, atleast not in terms of creating economic value, to continue to spur growth. Thus. growth durationis an important criterion for determining the length of the planning period. In order to identity thefinn's growth duration, we have to examine the company relative to its competition according tonumber of factors. Consideration should be given to the presence of established distributionchannels. any brand names and the research and development. For example, phannaceuticalcompanies have relatively long growth duration because of patented products and intense R &Davitivities.In order to estimate growth duration of a firm, we could make assumptions regarding the variablesthat affect a finn's FCFs. We would hold these variabres constant and then vary the length ofthe forecast until the present value of cash flows less debt is equal to the market value ofshares.The first part of finn's value, i.e. present value of all future FCFs, has two components present value ofFCFs generated in the planning period and present value of post planning periodof residual period FCFs. If we assume that a finn's strategic planning period is n years, thepresent value of the planning period FCFs for yeus I through n would be computed as follows:Present Value c1 %: ' c1"fl;ji . . offl.) The second pan requires two calculations. First. the value of the residual cash flows in yearn(the end of the planning period) with cash flows beginning in year (n l) and growing at aconstant rate (g) in perpetuity would be calculated as follows :Residual value in year n n

239Then, finally, we calculate the present value of post-planning period of residua) cash flow streamin the following way :Present value of residual cash flows rcs '.;.8 :;!uenTo continue, the value of non-operating assets (including items like marketable securities, excessreal estate etc.) is to be added. From the finn value. we can get the shareholder value bydeducting future claims of outsiders. Future claims includes both short-tenn and long-renn interestbearing debt and contigent liability. The value of each of these claims should be determined byasking the question : if this claim were to be settled now, what would have to be paid.In the above model, Ko is used as a discount factor. Kc, is an economic concept and representsthe cost that a firm has to bear in order to use capital. It is generally used in the sense ofweighted average cost of capital incorporating cost of all sources having regard to the weightsof these sources. The detennination of cost of equity, one of the important components, isgenerally frought with difficulties. Capital Asset Pricing Model (CAPM) is the ideal model to beused for the purpose.Forecasting FCFsTo detennine firm value on the basis ofFCFs, fll'Stly we have to determine the length of planningperiod and then to estimate the finn's future FCFs in doing so, we require estimating year toyear sales figure for the planning period and an annual sales growth rate assumed to be constantin perpetuity after the planning period. We then project both the firm's future cash flows fromoperations and the asset investments to be made over time.In the context of managing firm for shareholder value, FCF, rather than profit, is the keydeterminant of value. However, in forecasting a firm's FCF, we should not totally disregard the .information content of profit We could use this very well as a basis for predicting future cash ;i·flows themselves. Profit measures the results of operating cycles but involves judgments, wh reduce its credibility. But cash flows, on the other hand, involves less judgements.·At the beginning, the firm's historical is determined; then the industty in which itcompetes and its competitive position withihthe industry are required to be ascertained. Gsnerally.the following are the key issues of concern:Sales for the most recent.period.Sales growth rate for planning period and a growth rate that can be maintained in peq:,etuityafter the planning period.Expected operating profit margins (operating profit/sales).Projected ratio of operating assets to sales: net working capital, fixed assets and otherlong term assets relative to sales.Cash tax rate.These variables are called value drivers, because they are factors or drivers detennining afinn's free cash flows. which in tum affect firm value. As a beginning point for estimating the

240finn's cash flows, some assumptions regarding the above value drivers over the years aremade. These assumptions are based on the company's historical performance. adjusted forsome anticipated expected changes.In estimating future FCFs, depreciation expenses are not added to net profit as is generally donein computing historical FCFs. The assumption is that in looking forward in time, it is logical totake that the depreciation expenses is equal to the cost of replacing existing fixed assets.Depreciation is viewed as a proxy to reinvestment.EVA and its Use in Computing EV of the FirmWhile profit. no doubt, is the barometer of performance, the concept of profit differs significantlybetween accountant and economist. Accountanls measure profits from owners points of viewand as such, profits are measured as revenues less operating expenses less the cost of debtfinancing in the form of interest expenses and preference dividend. There is no cost. as such forequity capital; after all the shareholders are the owners to whom profits flow. But according toeconomists. profits represent that portion of revenue which is left with the business afterrecovering cost of all factors that are employed in the business activity. This is an age-old standof economists and its origin can be traced back to 1800s. True profits come only after subtractingall financing costs. both for debt capital and equity capital, where cost is defined as the opportunitycost of funds if they were to be invested in another firm of similar risk. In other words, thosewho speak of economic profits maintain that a business activity must not only break even butalso earn enough to justify the cost of all the capital used in pursuing the activity. Only then hasthe firm broken eve. Thus.Accounting SalesEconomicPtofit- Cost of goodssoldproftt Sales- Cost of esexpensestaxesChargeforall capital usedOr. Economic profit Net operating profits after taxes Charge for all capital used.EVA is based on this fundamental concept of economic profit. EVA is defined as any surplusgenerated from operating activities over and above the cost of capital (Ghosh, 2000). Technicallydefined, EVA is the quantitive measure of genuine addition or draining of the net worth ofshareholders and is calculated as net operating profit after tax but before interest reduced byweighted average cost of capital multiplied by the capital employed. It essentially seeks tomeasure the actual rate of return as against the required rate of return. It is a way to measurecorporate's real profitability recognizing the fact that the capital employed in any business has acost irrespective of general belief that equity has no cost. Thus, EVA is accounting for the costof capital and detennining the sufficiency or insufficiency of earning generated by a firm tocover the cost of capital, i.e. whether a firm is value creator or value destroyer.

241Although, EVA is primarily used as period-by-period performance measurement yet, StemStewart & Co., the originator of EVA concept. advocates the use of EVA in estimating EVA ofthe firm. It restates the FCF paradigm as : firm value is equal to the present value (PV) of aJJfuture EVAs plus invested capital. Thus Finn Value PV of future Invested CapitalEYAsPY of planningperiodEVAs PV of post planning Invested capitalperiodEYAsIn case of estimating future EVAs, we follow the same route as discussed earlier in section four.That is, we estimate the value drivers based on the analysis of historical performance of firmand industry suitably revised by expected future prospects and challenges.Reconciliation between FCF & EVA Valuation MethodIn this juncture, itis important to know how EVA relatestoFCFin determining rum's value. Byreconciling these two approaches we can say that value is independent of the perspective takenand the two methods are essentially tied to the same financial theory. Let us consider the caseof a hypothetical company (A Ltd.).The company projects the followings :oAnticipated sales for the year 2002 will be Rs. 3 crore on total beginning capital (debtand equity) of Rs. 1.5 crore.o Company expects to maintain a constant net operating profit after tax margin (NOPAT/Sales) of 6.25% over the future periods. This implies a NOPAT of (3 crorex 6.25%) orRs. 18,75,000which is 12.5% [(18.75 lakhs/lSOlakhs)x 100] of invested capital.oCompany is planning to reinvest 60% of its NOPAT for growth. Given the return oncapital of 12.5%, the firm is expected to grow at 7.5% (60% of the return of 12.591,).oThe company assumes lhat the 7.5% growth rate wilJ be continued for five years, theperiod management believes to maintain its competitive edge and also the time periodduring which it can continue to earn a rate higher than its cost of capital of 10%.oAfter the five year period, company expects growth will not create any additional valueand as such, company has no plan to expand.oCompany will be financing its entire investment to facilitate growth from internal sources(i.e. profit) and as such, no additional risk will be taken which in tum stabilizes cost ofcapital.

242Based on the foregoing projections, we can estimate the value of A Ltd. either by finding thepresent value ofFCFs or by computing the present value ofEVAs. The calculations are shownin Table I.TABLE IValuation of A Ltd. under FCF Method & EVA Method (Rs. in thousand)BVA based valualionPCP based ValuationYea,SalesNOPATlnvesuncntPrcseolFCF 0.6 x(3) (3)-(4)value orBeginningCapitalFCFCost ofEVAPresentCapital (3)-(8) Yaloeof (7) )2007andbeyond430692692PV oran F.C.F.(i.e. value or A. ainal Invested CapitalYalueALtd.-33464976ISOOO19976In the left hand side, FCFs (NOPAT less additional investment) are computed and in the rightside EVAs a.re computed (NOPAT- Cost of capital x Beginning capital). Since there will be noplan to grow in year 2007 and beyond, no additional investment will be made. In the year 2007,FCF, as a result, is estimated to be Rs. 2692 thousand. This FCF is expected to continue inperpetuity. The value of Rs. 2692 thousand annual perpetual cash flow stream at the beginningof 2007 (or at the end of 2006) is Rs. 2,69,20,000, determined as :PV of 'Residual Value' at FCF2007Kothe end of 2006 Rs. 2.69.20,QOO.

243Now, the PV of perpetual cash flow is calculated as :PV of 'Residual Value' at the PY of 'Residual Value' at the end of 2006(l Ko)'besinning or 2002Rs. 2,69,20,000(1 0.10)'Rs.l,67,IS,196.1be present value of all FCFs. i.e., the estimated value of A Ltd. is Rs. 19975 thousand. Similarsteps are followed in converting EVAs to their present values as on the beginning of 2002. Here.EVAs are computed by subtracting capital charge (equals of beginning capital miltiplied by costof capital) from NOPAT. 1be sum total of all present values of future EVAs is arrived at Rs.4976 thousand. When we add beginning capital invesbnent with the above figure. we get firmvalue of Rs. 19976 thousand - the exact outcome found with free cash flow method.The above illustration shows that both FCF and EVA method of estimating finn value yieldidentical result. Although it is a very simple and straight forward example. yet it suffices toconclude that, in theory, there is no significant difference between the two approaches, at leastnot when it comes to measuring firm value.lnspite ofno difference between FCF valuation and EVA based valuation. EVA method providessome additional insights that is lacking in case of FCF valuation method. The weakness ofFCFmethod is that it does not provide a readily apparent measure of annual performance. Free cashflow can be negative because of two reasons :i.Investment is high in profitable business. orii.Operating profitability is low in unprofitable business.In the year 1992, when Wal-Mart was one of the leading value creating firms. lhe firm had aFCFof (-)13 percent of capital while earning a rate of return 89& above its cost of capital. Atthe same time, K-Mart had a FCF equal to 79& of capital but earned a rate of return on capital39& below its cost of capital (Martin and Petty. 2000). Thus, FCF can be uninformative or evenmisleading. But EVA method provides a better measure ofannual perfonnance while maintainingconsistency with FCF valuation method.ReferencesRappaport, A.(1998) Creating Shareholder ¼llue: A Guide for Managers and Investors,The Free Press.Anjan V. Thakor. (2000) Becoming a Better Value Creator, UMBS Management Series, Jossey- Bess, San Francisco.Bany Sheely, Hyler Bracey and Rick Frazier, (1996) Winning the Race for Value, AmericanManagement Association, New York.·

244Bhaumik, Gautam. (2003) "Managing Economic ¼ilue of tho Firm", an unpublished article.Bhaumik, Gautam. (2002) "VBM - An Appraisal of Value Based Pe,formance Measures",M-Phil dissertaion. University of Calcutta.Davis, Erin. (1997) "What's Right About Corporate Cash Flow, Afloat in a Sea of Green",Fortune (March 31).El11bar, Al. (1998) EVA: The Real Key to Creating Wealth, John Wiley & Sons Inc., NewYork.ljiri, Yuji, (1980) "Recovery Rate and Cash Flow Accounting", Financial Executive (March).James Don Edwards and Honner A. Black, (1976) The Modem Accountant's Handbook.Dow Jones-Irwin, Illinois.John. D. Martin and J. William Petty, (2000) Value Based Management - the CorporateResponse to the Shareholders' Revolution, Harvard Business School Press.Kaplan, Steven N. and Richard. S. Ruback, (1995) ''Tho Valuation of Cash Flow FoIOCasts : AnEmpirical Analysis", Journal of Finance 50 (September).Madden, Bartley J., CFROI: (1999) A Total System Approach to Valuing tho Finn. Oxford :Butterworth-Heinemann.R.E.S. Boulton, B.D. Libert and S.M. Samek, (2000) Cracking the Value Code, Harper CollinsPublishers, Now York.Tully Shawn. (1993) ''The Real Key to Creating Wealth". Fortune (September).

239 Then, finally, we calculate the present value of post-planning period of residua) cash flow stream in the following way : Present value of residual cash flows rcs '.;.8 :;!uen To continue, the value of non-operating assets (including items like marketable securities, excess real estate etc.) is to be added. From the finn value. we can get the shareholder value by