428_Lecture8_DCF_S09 - Valuation Lecture 8 Free Cash Flow...

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Readings: Penman (2001) Valuation Lecture 8 Free Cash Flow
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Review: At beginning of the year, you bought 100 shares of XYZ company. How do you know you made a good investment by end of year? Suppose your bought it 10$ per share and price is $7 at the end of the year. You received $1 dividend for the year? Is it a good investment?
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Review: Suppose you are evaluating the performances of four mutual funds, each with different investing styles, LV, SV, LG and SG respectively. You have the their returns of last 10 years. What model do you use to give you a fair comparison?
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Review: DDM What is DDM? What are the advantages of DDM? What are the problems of DDM? What kind of investor you think should buy the firms that pay dividends?
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Free cash flow model Free cash flow model How to calculate and forecast free cash flows? Practical problems with free cash flow model
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The firm is earning money for both the equity holders and the debt holders. Free cash flow is the amount available to both. Idea of Free cash flow
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Valuing a Firm Cash flows generated by a firm’s real assets ultimately flow through to the shareholders and debtholders of the firm as dividends and interest Hence the present value of cash flows generated must be equal to the value of cash flows received Real assets Debtholders Shareholders Dividends Interest Reinvested Net cash flow + Principal
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The value of a firm is equivalent to the value of debt plus the value of equity, as follows: V F = V E + V D where: V F = the present value of CF generated by the firm V E = the present value of CF generated by equity securities V D = the value of CF generated by debt securities Valuing a Firm (cont’d)
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Cash flows from all projects for a going concern: 1 2 3 4 5 Cash flow from operations (in) Cash investment (out) Free cash flow Time, t C 1 C 2 C 3 C 4 C 5 I 1 I 2 I 3 I 4 I 5 C 1 -I 1 C 2 -I 2 C 3 -I 3 C 4 -I 4 C 5 -I 5 + ρ - + ρ - + ρ - = 3 F 3 3 2 F 2 2 F 1 1 F 0 I C I C I C V D 0 F 0 E 0 V V V - = The Discounted Cash Flow Model (DCF):
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The Continuing Value for the DCFM g I C CV F T T T - - = + + ρ 1 1 Capitalize terminal free cash flow with growth g g I C CV F T T T - - = ) ( OR. .. G G G
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DCF Valuation: New York State Electric and Gas
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Notice a couple of things 1) In DCF model, you want to use the discount rate for firm (cost of capital for the firm) rather than cost of capital for equity. In Dividend Discount Model, you use the equity cost of capital. We will discuss these costs of capital later. 2) We are ignoring tax here for now, but will introduce it later. 3) The growth rate G here refers to the gross growth rate (i.e. 1.09 rather than 0.09)
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Convert a price to forecast Free cash flow model How to calculate and forecast free cash flows?
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This note was uploaded on 09/23/2009 for the course AEM 4280 taught by Professor Ng,d. during the Spring '08 term at Cornell University (Engineering School).

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428_Lecture8_DCF_S09 - Valuation Lecture 8 Free Cash Flow...

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