Video Transcript: Corporate Valuation Model

Hello, welcome. We're going to discuss the corporate valuation model. So the  corporate valuation model is also known as the free cash flow method. Suggests the value of the entire firm equals the present value of the firm's free cash flow.  So we're going to project out free cash flows into the future. Remember, free  cash flow is what we have remaining at the end of a period in time after we  incorporate all inflows and outflows of cash. So what we have left between our  outflows and inflows gives us our free cash flow. Remember, free cash flows,  the firm's after tax, operating income, less net capital investment. So what  should we do? How do we find free cash flows? So we'll take earnings before  interest in taxes or EBIT, we'll multiply that times one minus the tax rate, we'll  add in our cost for depreciation and amortization. Then we'll subtract out capital  expenditures plus a change in net operating working capital. So essentially, what we're doing to find free cash flow is we'll take the net income component, which  is earnings before interest and taxes, then you subtract out the tax rate that will  give you net income plus depreciation, right. We still keep the depreciation in  amortization function in our equation. Then we'll subtract out cap x, so our  change in net operating working capital will cancel out the amortization piece,  because that's what happens, right? So when we have a change in net  operating working capital, our working capital is being amortized, so we can  cancel those out, so now we'll have net income plus depreciation, minus our  capital expenditures. So let's look at the components of the free cash flow  model. So operational cash flow is earnings before interest and taxes. We need  to find out our corporate effective tax rate and subtract out the tax rate or the  taxes we need to define depreciation, know what that is, calculate it and then  know what we are spending on capital expenditures. Then the horizon value is  going to be the future value of cash flow in the future. Weighted average cost of  capital is our average cost to fund our company. So we have our our financing  structure with a ratio of debt to equity. So let's say we have 50% debt, 50%  equity, right? So our weighted cost of capital would be, let's say the equity is  costing us 8% and the debt is costing us 12% and we are 50% capitalized with  equity and 50% capitalized with debt that would bring our cost of capital to 10%  because we have 12% financing with debt and we have 8% financing with  equity, we are bulk. They are both weighted at 50% so our weighted average  cost of capital would be 10% long term growth rate that will be identified our  outstanding debt and our number of shares outstanding of common stock,  applying the free cash flow model, find the market value of the firm by finding  the Present value of the firm's future cash flows, subtract out the marginal value  of the firm's debt and preferred to stock. If there is any to get marginal value of  the common stock. I need to start this. I need to start the slide over. Okay, sorry,  yeah, okay, okay, okay, right. Okay, yep. So applying the free cash flow model,  right, we need to find the market value of the firm by finding the present value of  the firm's future cash flows, right? Then we subtract the market value of the 

firm's debt and preferred stock, if there is any to get the market value of our  common stock, then we divide the market value of our common stock by the  number of shares outstanding to get the intrinsic. Stock price. What are  weighted average cost of capital? And what is G? Weighted average cost of  capital is the rate at which your cash flows are discounted, right? So this is for  this example. This is the use of the weighted average cost of capital. It's what  we're going to discount our cash flows by the wave average cost of capital. So  growth is the long term growth of cash flows. This is our assumption for  sustainable growth, growth that can go on forever. Assume the following  information, Ramirez company has these cash flows, right? Year one, negative  five, then they get positive with a $10 cash flow, and this is a simplistic model,  right? And then $20 cash flow in year three, you will know that the cash flows  will grow at a constant rate of 6% and after after year three, though, right? So  this is after year three. We will have the cash flow growth after year three.  Assume also that the rate of return in the market, right is 10% so our weighted  average cost of capital is 10% we need to at least get 10% return to break even, as our weighted average cost of capital is 10% so therefore, to break even, we  need to get a 10% return. So we'll use our wage, average cost of capital as our  return measurement, and that the company has $40 million in debt, 40 million in  debt, and there are 10 million shares outstanding. okay, so now we want to  project out the present value of our future cash flows. So we're just going to use  the present value function. We'll plug it in to our financial calculator. So present  value of cash flow and period one is a negative 4.545 period two is 8.264 period  three is 15.026 now we can get period four free cash flows, because we know  that after year three or period three, that growth equals 6% so we'll take 20  times the growth rate point 06, and that will give us our year four cash flow.  2120, okay, so now we want to find our horizon value, right? We want to find our stock price at the end of year four. So we'll take our cash flow divided by the  return on the market at 10% subtract out our growth rate. This will give us $530  we'll discount that back to 398, point 197, so these cash flows is the future cash  flow. These cash flows four, one, 6.92 so these are the combination of the  culmination of our free cash flows at the end of year four. So now, so now we  want to know what is the price of our company. So now we have the future cash  flows. We know that we have 10 million shares outstanding. This is our stock  price on our future cash flows. So we know we have 10 million shares  outstanding. So to get the corporate valuation, or the value of our firm, firm  value, we will take the 416 92 and multiply it by 10 million. So we'll take the 416  Point nine two, and multiply it by 10 million. So 10 million times 4.1, 6.92 this will give us a corporate value. So 4,169,200,000 is our corporate valuation based on our free cash flows. 4.1 7 billion is our value of our corporation based on these  cash flows.