15.3 Free Cash Flow to Equity (FCFE)

Discount the stream of free cash flow available to pay shareholders:

\[\begin{equation} \begin{array}{l} FCFE = & &NI &\cdots \:\: (1) \\ &+ &Non \:Cash\:Charges &\cdots \:\: (2) \\ &- &\Delta Working \:Capital &\cdots \:\: (3) \\ &- &\Delta Capital &\cdots \:\: (4) \\ &+ &\Delta Debt &\cdots \:\: (5) \\ \end{array} \tag{15.3} \end{equation}\]

  • FCFE is free cash flow after:

    • Paying interest on debt

    • Tax benefits of the interest payment

    • Net borrowings

  1. \(NI\) is net of interest payments to shareholders, after tax

    • \(\Delta\) loss reserve reflected in \(NI\) only
      (It gets net out as non-cash charges and capital expenditures assuming changes in reserve does not impact required capital)

  2. \(\Delta\) Working Capital is negligible for P&C insurer

  3. This is change in required capital

Growth rate

\[g = \underbrace{\dfrac{\text{Net Income after Tax}}{\text{Beginning Equity}}}_{ROE} \times \underbrace{\dfrac{\Delta Capital}{NI}}_{\text{Reinv. Rate}}\]

  • Assume portion of FCF not paid out is invested at \(k\)

  • Similar to DDM, calculate the \(ROE\) and reinvestment rate for all years and make a pick

Free Cash Flow

  • Cash flow available to pay out to the firm’s source of capital (for FCFE this is only to equity) net of amounts required to be reinvested to the firm for growth

  • Weakness: require forecasting financial statements, use adjusted accounting measure, large terminal value

FCFE vs FCFF

  • We don’t use the free cash flow to firm because there’s additional leverage for p/h liabilities from reserves held

  • Not clear how to calculate cost of capital due to leverage from 2 different source and it complicates the calculation

  • Using FCFE removes the source of leverage

Discount rate

  • FCFE pays out all free cash flow while DDM only pays out a portion (rest in marketable securities)

  • DDM has a larger portion of its risk profile from investment in securities and FCFE has a larger portion from u/w risk

  • Should use different discount rate

  • But difference is difficult to quantify \(\Rightarrow\) Use the same discount rate

Advantages over DDM

  • Dividend are discretionary

  • Firms also return funds via stock buybacks

  • Focus on free cash flow