 Hello and welcome to the session. This is Professor Farhad in the session. We would look at the free cash flow valuation approach. What does that mean? First, we have to understand how we compute the free cash flow. What does that mean? Then we are going to use it to value a company, to put a price, to put a value on a company. As always before I start, I would like to remind you to connect with me only then, subscribe to my YouTube to view additional lectures and on my website, farhadlectures.com you will find additional courses and resources for this course as well as your accounting courses, especially if you are studying for your CPA exam. So let's go ahead and start with the free cash flow valuation approach. So simply put, what is the free cash flow? What does that mean? It means am I getting cash for free? Not at all. It's how much cash would I receive if I was an investor? What does that mean? It means if you are an owner in this company, how much cash would you receive? Think about if you are an owner in a business. Let's assume you own your own business. You want to know how much cash you would receive after you deduct certain things that we are going to deduct. Like for example what? For example, if you have a business, you need to operate the business. You need to pay for your expenses, operating expenses. You also need to invest in the business itself. You may wanna buy new equipment, new machinery, new vehicles. So those are expenditure you have to pay for, you have to commit to. That after all things are done, what's left to you as an investor, as the owner is the free cash flow? There's a specific formula that we're gonna go over, but this is the basic idea. How much would I get? I'm the owner. How much would I get? What's the discretionary cash flow? Cash flow that I can take from this business and do anything with it. Now the more that amount is, the better off I am. Now why do we use this free cash flow? Why do we have to compute this free cash flow? Because not all companies pay dividend. And if you remember, if the company paid dividend, what happened is you can use the dividend discount model. If you remember the dividend discount model will take D1, the future dividend divided by K, which is the required rate of return minus G to value a company. Well, if the company don't pay dividend and a lot of companies don't pay dividend. So how do we value a company? What's gonna happen? I'm gonna give you the answer now. We're gonna replace this D1 by the future cash flow. That's all. That's all we're gonna be doing basically. That's the basic idea. So if you understand the dividend discount model, this should be easy to understand. We're gonna use some accounting terminology here and there, but the idea is the same. So it's basically an alternative approach to the dividend discount model to value a company using the free cash flow. What is the free cash flow? It's the cash flow available to the firm. It's available to the firm in a sense that they can do anything with it. It's dur. They can meet and say, okay, now this is how much cash we have after we commit it to everything we need to commit and pay for. It's all the cash that's available to the equity holders, to the owners of the company net of capital expenditure after we invest what we need to invest in the company to grow. So the free cash flow models are valid for any firm because all firm will have cash flow. Therefore you can use this free cash flow model. Obviously you want it to be positive, not negative and can provide a useful insight about the firm beyond the dividend discount model because cash is what matters. When you run a company, when you invest in a company, what matters for analysts, what matters for managers, what matters for owners is how much cash am I going to receive at the end of the day because this is why you invest in a company, okay? So you're gonna discount this free cash flow. We're gonna see how we compute this. The FCFF at the weighted average cost of capital. We already know what weighted average was, the capital whack to find the value of the firm, so notice what it says here, we said free cash flow model. So there's more than one model, but we're gonna, you know, they're all basically the same. The first thing we want to start with is how do we compute the free cash flow to the firm? So how do we get to that number? Well, the free cash flow to the firm is the after tax cash flow generated by the firm operating net of. So after the cash flow, after we pay taxes, but we still have to pay for investments in capital, especially if the company is growing, that's a big expenditure. For example, a company like Amazon, they do generate cash flow, a lot of it. But what happened is they take this cash flow and they reinvest in the company. Same thing with Netflix, they reinvest in new movies. And networking capital, what's networking capital? Current assets minus current liabilities. You need to buy inventories, you need to buy supplies. You need to finance your account receivable. So you need this money to run your business. So after you take care of your investments, after you take care of your investments, after you take care of networking capital, what's left? You can do whatever you want with it. You can give it to the owners, you can do whatever, okay? But usually you will give it to the owners. That's why owners invest in the company to get that free cash flow. So it includes cash available to both debt and equity holders. And it's equal to, so this is how we compute the free cash flow. We're gonna take EBIT, which is earning before interest and taxes, times one minus the tax rate. We're gonna explain each component separately. We're gonna add back the depreciation. Not only the depreciation, we'll add back depreciation. We'll add back amortization. We'll add back that expense. We add back any expense that we took that was not a cash flow. So simply put, when we are computing our earnings, how do you get to EBIT? How do you get to EBIT? You take your sales minus your expenses. You're operating expenses. Now part of your operating expenses are non-cash expenses, mainly depreciation. When we talk about non-cash expense, you think of depreciation. But depreciation is not the only non-cash expense. You have amortization, but that expense. Therefore what we need to do to find the free cash flow for the firm, you need to add back depreciation. Then you need to deduct capital expenditure because capital expenditure is not on the income statement. Capital expenditure is how much you are planning to invest in property, plant, and equipment to grow your company. Then you subtract any increase in networking capital. Networking capital means how much you will need mainly inventory and supplies to operate your business because that's what you need to keep on running the company. So EBIT is earning before interest and taxes. Now why do we take EBIT before interest and taxes? Then we multiply it one minus the tax rate because when we compute EBIT, when we compute earnings before interest and taxes, we are going to have some expenses here that are non-cash. And I already told you like depreciation, but those expenses, they're gonna give us a tax break because we have those expenses embedded in this number, embedded in EBIT, included in EBIT. Well, what's gonna happen? It's gonna reduce our tax bill. And after we reduce our tax bill, we add back those expenses that were non-cash, such as depreciation. And don't worry, we'll work an example. But this is basically why we take EBIT multiplied by one minus the tax rate to pay the taxes first. Then we add back the expenses that they were not in cash because those expenses were good for us. They served us well because they reduced our tax bill. TFC is the corporate tax rate. NWC is networking capital, which is current assets minus current liabilities if it was not giving them the problem. So EGLE products EBIT is $620. Its tax rate is 30%. Its depreciation is $35. Let me show you the effect of this. So if EBIT is 620, it means you're gonna take 620 times 0.3. And why are we doing this? We are doing this to find our tax bill. So 630 times 0.3 equal to 186. Then what we do, we're gonna take this one, we're gonna add to the 186, this 35 million or 35,000 or whatever 35 of, okay? We're gonna add back the depreciation. Now, why do we do this? Why do we do this? Here's what happened. When we computed our, when we computed the 620, we took sales minus various expenses, we came up with 620. Now, within those various expenses were $35 of depreciation. Let's assume that $35 wasn't there. So if that $35 wasn't there, our EBIT would have been, at 35 would have been 620 plus 35 is 655 times 0.3. Let's do 655.3 times 0.3. That's gonna give us a tax bill of $196 and 50 cent. So what I'm trying to say is, because the depreciation was a non-cash expense, it reduce our tax bill from 186, reduce our tax bill from 196 to 186. All what I'm trying to illustrate is the effect of a tax deduction on your tax bill. Simply put, by including depreciation, you reduced your tax bill, okay? Now, another way to find the difference is you'll take 35% times, let's find first, let's find the difference, 196.5 minus 186. Just I will show you how it works. 196.5 minus 186. So you saved yourself $10 and 50, 10.5 million or $10 and 50 cent. Simply put, how can I find this $10 and 50 cent? I will take 35 times 0.3, 35 times 0.3. Let's me do it, 35 times 0.3. It's gonna give me $10 and 50 cent. So simply put, by having 35 million of depreciation, that saved me 10.5 million on my taxes. I hope this makes sense. And you see the difference between the tax bill. Therefore, I will take EBIT, compute my taxes, then add back non-tax expenses because those non-tax expenses helped me substantially in reducing my bill. So I'm gonna take, so simply put, I'm gonna take this, pay the taxes, 30%, add 35, subtract my capital expenditure, deduct the increase in working capital. I'm gonna find my free cash flow. Therefore, I'm gonna take EBIT times, pay my taxes, add back my depreciation. The depreciation helped me reduce this taxes, subtract my capital expenditure, subtract my increase in working capital. And this money, the board of directors are going to meet and decide they can do whatever they want with it. And the higher this number, the better off you are as an owner and the higher is the value of the company. Just the more free cash flow you have, you can do whatever you want with it. Now you're gonna take this free cash flow and remember the dividend discount model, D1 divided by K minus G, same concept. We're gonna take the free cash flow. This is basically summarizing the formula. Rather than K, rather than the required rate of return, we're gonna use the weighted average, cost of capital minus G. So that's basically the same concept, basically the same concept. Let's take a look at an example to illustrate this concept. The Adam corporation cash flow from operation before interest, depreciation, and taxes was 1.8. So EBIT is 1.8. And expect that this will grow at 5% per year. So G for this example equal to 5%. So expect to grow at 5%. To make this happen, the firm will have to invest an amount equal to 18% of pre-tax cash flow per year. So simply put, what we're saying in this statement is for us to grow at 5%, we have to take whatever we have in cash flow, 18% of that and reinvest in the company. So simply put, we're gonna have to reinvest 1.8 times 18%. That's gonna be our capital investment to keep on growing, to keep on growing. You have to keep buying property, plant, and equipment, and expand your company. The tax rate for our purposes is 21%. Depreciation was 240,000 and expected to grow at the same rate as the operating cycle. So it's gonna expect to grow at the same rate. The appropriate market capitalization rate, K, and here we're gonna assume K and WAC are equal to each other for the unleveraged cash flow is 11%. Simply put, the required rate of return or the WAC is 11%. And currently we have 4 million in outstanding debt. Use the free cash flow approach to calculate the value of this firm. So how much is this firm is worth? Well, let's start with EBIT. EBIT is 1.89 to be more specific, 1.89 million. 1,890,000. Then we're gonna have to add depreciation to it. That's gonna give us taxable income because this was, notice here, it's before depreciation. Before depreciation. Therefore, we add depreciation, then we compute our taxes. Our taxes are 343,980. So we're gonna deduct the taxes. We're gonna deduct the taxes and come up with 1,294,020. And we're gonna add depreciation. Okay, we're gonna add depreciation to it. Okay, so we're gonna subtract the taxes. Obviously, we're gonna subtract the taxes. Then this is, then we're gonna add, we're gonna add the depreciation. We're gonna add the 252 to come up with after tax unleveraged income plus depreciation. Now, we're gonna take, now we're gonna subtract the capital expenditure. Remember, the capital expenditure is 1.89 million multiplied by 18%, which is 340,200. So after tax, after we deduct the capital expenditure, we are left with 1,205,820. Now we can find the value of the firm. We'll take this number, the free cash flow, divided by K, which is, again, we're gonna assume the K and whack are the same here, minus G, and the value of the firm is 20,097,000 dollar. Now, it's easy now, you can take this and divide it by the number of shares to find out what's the price per share, but the value of the firm overall is 20,097,000 dollar. If you like this recording, please like it and share it. Don't forget to visit my website, farhatlectures.com. If you are studying for your CPA exam, make sure to visit my website. I do have additional resources that's gonna help you succeed. You're gonna study for your exam once in your lifetime, it's a lifetime investment, okay? So don't shortchange yourself. At least if you don't want anything from my website, go check how your university stand up against other universities in terms of the CPA exam. Study hard, good luck, and most importantly, stay safe.