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Damodaran_FCF_overall_firm_value

Damodaran_FCF_overall_firm_value - GROWTH IN FCFE VERSUS...

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1 GROWTH IN FCFE VERSUS GROWTH IN FCFF Leverage generally increases the growth rate in the FCFE, relative to the growth rate in the FCFF. The growth rate in earnings per share is defined to be: g EPS = b (ROC + D/E (ROC -i (1-t))) where, g EPS = Growth rate in Earnings per share b = Retention ratio = 1 - Payout ratio ROC = Return on Assets = (Net Income + Interest Expense (1-t))/(BV of Debt + BV of Equity) D/E = Debt/ Equity i = Interest Expense/ Book Value of Debt The growth rate in EBIT will be a function of only the retention ratio and the return on assets and will generally be lower: g EBIT = b (ROC) Illustration 12: Growth rate in FCFE and FCFF: Home Depot Inc. Home Depot Inc. had earnings per share in 1992 of \$0.82, and had registered growth in earnings per share of 45% in the prior five years. The firm had return on assets of 12.82 %, a pre-tax interest rate of 7.7%, a debt-equity ratio of 36.59% and a retention ratio

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2 of 91% in 1992 (The tax rate was 36%). Assuming that these levels will be sustained in the future, the growth rates in FCFE and FCFF will be as follows: Expected growth rate in FCFE = b (ROC + D/E (ROC -i (1-t))) = 0.91 (12.82% + 0.3659 (12.82% - 7.7% (1-0.36)) = 14.29% ExpectedGrowth rate in FCFF = b (ROC) = 0.91 * 12.82% = 11.67% The growth rate in free cashflows to equity is greater than the growth rate in the free cashflow to the firm because of the leverage effect.
3 VII. FCFF STABLE GROWTH FIRM The Model A firm with free cashflows to the firm growing at a stable growth rate can be valued using the following model: Value of firm = FCFF 1 / (WACC - g n ) where, FCFF 1 = Expected FCFF next year WACC = Weighted average cost of capital g n = Growth rate in the FCFF (forever) The Caveats the growth rate used in the model has to be reasonable, relative to the nominal growth rate in the economy. the relationship between capital expenditures and depreciation has to be consistent with assumptions of stable growth. Illustration 13: Valuing the Food Product Division at RJR Nabisco A Rationale for using the Stable FCFF Model The division is in steady state; It is a large player in a stable market with strong competition. It cannot be expected to sustain high growth for any length of time.

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4 The division does not carry its own debt (though its parent company, RJR Nabisco, carries plenty). Thus, only the FCFF can be computed for the division. The entire division is up for sale, not just RJR’s equity stake in the division. Background Information In 1995, the food products division had revenues of \$ 7 billion on which it earned \$1.5 billion before interest and taxes. The division had capital expenditures of \$660 million and depreciation of \$550 million in 1994. The working capital as a percent of revenues has averaged 5% between 1993 and 1994. (Working capital increased \$350 million in 1994) The beta of comparable firms in the food products business is 1.05 and the average debt ratio at these firms is 23.67%. (The cost of debt at the largest of these firms is approximately 8.50%).
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Damodaran_FCF_overall_firm_value - GROWTH IN FCFE VERSUS...

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