Friday, March 9, 2012

Operating Free Cash Flow Discounting Model

 Index of concepts
  1. Aa to Az
  2. Ba to Bz
  3. Ca to Cz
  4. Da to Dz  
  5. Ea to Ez
  6. Fa to Fz
  7. Ga to Gz
  8. Ha to Hz
  9. Ia to Iz
11. Ka to Kz
24. Xa to Xz

Subject: Investment Analysis

Chapter/Topic: Valuation of Equity Shares


Concept Definition and Explanation


Operating free cash flow is free cash flow before the payment of interest to the debt holders but after deducting funds needed (capital expenditure) to maintain the firm’s assets bases.  Free cash flow to the firm also refers to the same thing. These cash flows are discounted using the firm’s weighted average cost of capital (WACC). The discounted value will be the total value of the firm and it includes the value due to the bond holders and other lenders.


V =  Σ CFt/(1+i)t   [t = 1 to ∞]


 V = value of the firm

CFt    = operating free cash flow of the firm in year t

i   = WACC of the firms


For a mature firm, whose growth is less than that of WACC and can be estimated as a constant rate, we can use the simplified formula:

 V = CF1/(i – g)

 CF1    = operating free cash flow of the firm in year 1

g =  constant growth rate for infinite period.

 If firm has presently high growth rate, the cash flows can be modeled as two stage model with one stage having high growth rate and the second stage having infinite growth rate.

 Operating free cash flow or free cash flow to the firm is equal to

 EBIT(1- Tax Rate) + Depreciation Expense – Capital Expenditures – Change in Working Capital – Change in Other Assets

 Using the above formula Operating free cash flow can be calculated from projected financial statements.


Reilly, Frank and Keith Brown, Investment Analysis and Portfolio Management, 7th Edition, Thomson-South Western, 2003



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