Answer The Following Questions: Why Is Free Cash Flow (FCF)
Answer The Following Questionswhy Is Free Cash Flow Fcf Important A
Answer the following questions: Why is free cash flow (FCF) important and how does it help investors? Please discuss. Also, explain how to use the free cash flow valuation model to find the price per share of common equity. Suppose a firm estimates its overall cost of capital for the coming year to be 10%. What might be reasonable costs of capital for average-risk, high-risk, and low-risk projects? 350 word minimum. APA format
Paper For Above instruction
Free cash flow (FCF) is a critical financial metric that represents the cash generated by a company’s operations after deducting capital expenditures necessary to maintain or expand its asset base. It is vital for investors because it provides a clear picture of the company’s ability to generate cash that can be returned to shareholders through dividends, share repurchases, or used to pay debt. Unlike net income, which includes non-cash expenses and accounting assumptions, FCF measures actual cash liquidity, giving investors a more accurate assessment of a company's financial health and dividend-paying capacity (Damodaran, 2012).
Moreover, FCF is essential for valuation purposes since it forms the foundation of the discounted cash flow (DCF) model. The DCF method involves estimating the company’s future free cash flows and discounting them back to their present value using an appropriate discount rate, typically the company’s weighted average cost of capital (WACC). This process allows investors to determine the intrinsic value of a company's equity. Specifically, the value of equity per share can be calculated by estimating the firm’s future free cash flows, discounting these to the present, and then dividing the total enterprise value minus net debt by the number of outstanding shares (Koller, Goedhart, & Wessels, 2010). This approach helps investors make informed decisions about whether a stock is undervalued or overvalued relative to its intrinsic value.
Regarding the cost of capital, for the coming year, the firm estimates a 10% overall cost of capital, which reflects the average risk of the firm’s projects or operations. For different levels of project risk, the costs of capital would adjust accordingly. Typically, average-risk projects may warrant a cost of capital close to the firm’s overall rate, around 10%. High-risk projects, given their increased uncertainty and potential for higher returns or losses, justify a higher discount rate, often between 12% and 15%. Conversely, low-risk projects, which are more stable and predictable, may warrant a lower cost of capital, approximately 8% to 9%. These estimates help in making investment decisions, ensuring that risk-adjusted returns are appropriately evaluated to balance potential gains against possible losses (Brealey, Myers, & Allen, 2019).
References
- Brealey, R. A., Myers, S. C., & Allen, F. (2019). Principles of Corporate Finance (12th ed.). McGraw-Hill Education.
- Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset (3rd ed.). Wiley.
- Koller, T., Goedhart, M., & Wessels, D. (2010). Valuation: Measuring and Managing the Value of Companies. Wiley.