Valuing Rio's equity by the free-cash-flow-to-eq

The spreadsheet below shows how the free-cash-flow-to-equity method can be used to value Rio’s
version of Table 19.1 and sets out Rio’s forecast cash flows assuming it is all-equity financed. Notice
cash flow that year ($ 6 million) and the present value of all subsequent cash flows ($113.4 million)
figure, as we did in Figure 19.1, by using WACC to discount future cash flows assuming all-equity fin
by comparing Rio with similar traded companies.

Panel B shows how to use the free-cash-flow-to-equity method. The trick is to start with the final y
present. We first need to calculate the level of debt at the end of year 5 since this will determine th
firm has constant leverage, the formula for calculating the debt level in year t is D t = (Ct+1 + Dt+1 +Et+1
where Ct+1 is the company cash flow assuming all-equity financing, D t and Et are the present values o
the constant ratio of equity to debt, rD and rE are the costs of equity and debt, and T c is the corporat
level of debt in year 5 as
Dt = (119.4 + 0 + 0)/((1.124)(.6/.4) +(1 + (1 - .35).06)) = 43.8

We can now calculate the free cash flow to equity in year 6 as the total cash flow under all-equity fi
interest payment and plus the net increase in the amount of debt (D t+1 – Dt). Row 2 repeats Row 10
cash-flow in Year 6 under all-equity financing is 119.4. Row 3 shows that the after-tax interest paym
4 shows that the net issue of debt in Year 6 is -43.8. Therefore the free-cash-flow to equity in Year
Row 6 shows that the present value in Year 5 of this free cash flow is 73.9/1.124 = 65.7.

Having calculated the equity value in year 5, we can work back a year at a time to find the value at y
the equity is E = 52.7 and the value of the firm is D + E = 35.2 + 52.7 = 87.9. The final row of Panel B
the debt ratio at each year is .4.

1
We can derive the DCF formula for flow to equity in the same way as in footnote 3. Start with the
investors. The expected payoff ET-1(1 + rE) is reduced because outstanding debt D T-1 must be paid off
payoff as free cash flow to equity, FCFET:
ET-1(1 + rE) = CT – DT-1 – rD(1 – TC) DT-1 = FCFET
FCFET
E T -1 =
1 + rE
At T – 2, equity investors look forward to the equity value E T-1 at T – 1 and to FCFET-1. FCFET-1 includes
is negative if debt is paid down.
ET-2(1 + rE) = ET-1 + CT-1 – (DT – DT-1) – rD(1 – TC) DT-1 = ET-1 + FCFET-1

Substitute for ET-1 and solve for ET-2.

FCFE T -1 FCFE T
E T -2 = +
1 + rE (1 + rE ) 2
 FCFE T -1 FCFE T
E T -2 = +
1 + rE (1 + rE ) 2
At date 0,

FCFE t
E 0 = �1
T

(1 + rE ) t
Notice that we have assumed that the cost of equity is constant. The cost of equity depends on fin
assumed that the future debt ratio is constant. In other words, we assumed that the change in deb
the project or firm.

PANEL A Calculating Rio's free cash flow with all-equ

0 1

1. Sales 89.5
2. Cost of goods sold 66.2
3. EBITDA (1 - 2) 23.3
4. Depreciation 9.9
5. Profit before tax (EBIT) (3 - 4) 13.4
6. Tax 4.7
7. Profit after tax (5 - 6) 8.7
8. Investment in fixed assets 14.6
9. Investment in working capital 0.5
10. Free cash flow, Ct (7 + 4 - 8 - 9) 3.5
Note: Free cash flow for year 6 includes the present value of all later cash flows

Assumptions:
11. Working capital (percent of sales) 13.0
12. Net fixed assets (percent of sales) 79.2 79.0
13. Depreciation (percent of net fixed assets) 0.0 14.0

14. Tax rate, percent 35.0

15. Cost of debt, percent (rD) 6.0
16. Cost of equity, percent (rE) 12.4
17. Debt ratio (D/V) 0.4
18. WACC, percent 9.0

Fixed assets and working capital

19. Gross fixed assets 95.0 109.6
20. Less accumulated depreciation 29.0 38.9
21. Net fixed assets 66.0 70.7
22. Net working capital 11.1 11.6
 PANEL B Valuing Rio's free-cash-flow to equ

Formula for calculating year t debt with annual rebalancing: Dt = (Ct+1 + Dt+

1 Debt at year t (Dt) from formula 35.2 36.9

2 Free cash flow, Ct (from Panel A) 3.5

3. - Net interest payment -1.4
4. + Net issues of debt = 1.8
5 Free-cash-flow to equity (2 + 3 + 4) 3.9

6 Present value of equity (Et) at year t 52.7 55.4

7 Present value of firm (1 + 6) 87.9 92.3

8 Check: D/V (1/(1 + 6)) 0.4 0.4

d
e
d+e
e free-cash-flow-to-equity method
an be used to value Rio’s equity. 1 Panel A is an abbreviated
l-equity financed. Notice that in year 6 we have combined the
sh flows ($113.4 million). We could have arrived at the latter
ws assuming all-equity financing, or we could have estimated it

s to start with the final year (year 6) and work back to the
ce this will determine the interest payment in year 6. If a
r t is D t = (Ct+1 + Dt+1 +Et+1)/((1 + rE)(E/D) +(1+(1 – Tc)rD)),
t
are the present values of debt and equity in year t, E/D is
bt, and T c is the corporate tax rate. Thus Row 1 shows the

h flow under all-equity financing (C t,) less the after-tax

). Row 2 repeats Row 10 of Panel A. It shows that the free-
he after-tax interest payment is (1 - .35) x .06 x 43.8 = 1.7. Row
h-flow to equity in Year 6 is 119.4 – 1.7 - 43.8 = 73.9 (Row 5).
1.124 = 65.7.

time to find the value at year 0. You can see that the value of
The final row of Panel B provides a precautionary check that

otnote 3. Start with the expected payoff at the last date T to equity
debt D T-1 must be paid off with interest after tax. Define the

o FCFET-1. FCFET-1 includes the change in debt D T-1 – DT-2, which

of equity depends on financial leverage, so we have implicitly also
d that the change in debt is proportional to the change in the value of

ee cash flow with all-equity financing

Forecast
2 3 4 5 6

95.8 102.5 106.6 110.8 115.2

71.3 76.3 79.9 83.1 87.0
24.4 26.1 26.6 27.7 28.2
10.6 11.3 11.8 12.3 12.7
13.8 14.8 14.9 15.4 15.5
4.8 5.2 5.2 5.4 5.4
9.0 9.6 9.7 10.0 10.1
15.5 16.6 15.0 15.6 16.2
0.8 0.9 0.5 0.6 0.6
3.2 3.4 5.9 6.1 119.4
l later cash flows

13.0 13.0 13.0 13.0 13.0

79.0 79.0 79.0 79.0 79.0
14.0 14.0 14.0 14.0 14.0

125.1 141.8 156.8 172.4 188.6

49.5 60.8 72.6 84.9 97.6
75.6 80.9 84.2 87.5 91.0
12.4 13.3 13.9 14.4 15.0
o's free-cash-flow to equity

balancing: Dt = (Ct+1 + Dt+1 + Et+1)/((1 + rE)E/D +(1+(1 – Tc)rD))

39.0 41.1 42.4 43.8 0.0

3.2 3.4 5.9 6.1 119.4

-1.4 -1.5 -1.6 -1.7 -1.7
2.0 2.1 1.3 1.4 -43.8
3.8 4.1 5.6 5.8 73.9

58.4 61.6 63.7 65.7 0.0

97.4 102.7 106.1 109.5 0.0

0.4 0.4 0.4 0.4

1 2 3 4 5 6
3.462668 3.2242071 3.4499016 5.88431488 6.11968747 119.3899 6.8
87.888754 92.336074 97.422113 102.740202 106.102505 109.532
3.1767596 2.7137506 2.663957 4.16859701 3.97737696 71.18831 87.8888
35.155502 36.93443 38.968845 41.0960808 42.4410021 43.81282
52.733252 55.401644 58.453268 61.6441212 63.6615032 65.71923
87.888754 92.336074 97.422113 102.740202 106.102505 109.532