Forecasting FCFF and FCFE

Say that Kutner Pharmaceuticals develops a revolutionary new drug to cure multiple types of cancer. That's a significant breakthrough! And that significance would lead to lives being saved, an increase in Kutner's value, and positive returns flowing to investors. But computing Kutner's value could prove to be difficult. Why would that be the case?

That's it! In fact, both answers are correct. Kutner's value would be difficult to project because the historical financial data wouldn't capture the new breakthrough, so FCFF would need to be forecast. Thankfully, a couple of different approaches are available to help forecast FCFF.

The first method applies a constant growth rate to Kutner's current level of free cash flow. So in this case, you could assume that Kutner's historical rate would continue and that the historical relationships between cash flow and items like net income, depreciation, and interest expense would remain the same. But what might the new drug do that could make this approach a bad idea for forecasting Kutner's FCFF?

No. In that case, the historical trend would continue, and the constant growth rate could be used.

No, actually. While the new drug might cost more to produce, it will also bring in more free cash flow, so that's not the best reason for using a different FCFF model.

You got it! Kutner's new breakthrough drug will definitely change the historical relationships between free cash flow and sales, expenses, noncash charges, and investments in working and fixed capital. That's why a better approach might be to forecast Kutner's future FCFF by estimating the future components of free cash flow.

So the first place to start is pretty clear: sales! If Kutner is going to have increasing sales from the new drug, those should be the starting point for the forecast, so you'd need sales growth forecasts to help forecast EBIT. But you'd also need another ratio to help complete the EBIT forecast for Kutner's FCFF. Which ratio would help?

Yes! You'd need to forecast after-tax operating margin to compute Kutner's FCFF to include expenses. Note that in computing FCFF, you'd use the after-tax operating margin because interest expense should be included in FCFF as a return of capital to bondholders. But for Kutner's FCFE, you'd use _profit margin_ because interest expense should be removed to reflect only cash flows available to equity holders.

No. The gross profit margin wouldn't capture selling general and administrative costs.

That's not it. Debt to assets wouldn't help in computing EBIT.

From this point, you'd also need to compute how fixed capital investment and working capital investment are impacted by the new drug. In most cases, you can assume that Kutner's fixed capital investment to sales and working capital investment to sales will remain the same. So to find fixed capital investment, start by multiplying the past proportion of incremental fixed capital investment to sales increase by the forecasted sales increase. And then you have the formula for the incremental fixed capital investment as a proportion of sales increase. $$\displaystyle \frac{\mbox{Capital Expenditures - Depreciation Expense}}{\mbox{Increase in Sales}}$$ So this means that depreciation expense is subtracted from the fixed capital investment amount. Why do you think it's subtracted?

Depreciation represents the investment in maintenance capital. So it's subtracted from fixed capital investment so that the proportion that grows with sales is the growth capital investment. And the formula for working capital is $$\displaystyle \frac{\mbox{Increase in Working Capital}}{\mbox{Increase in Sales}}$$. So just like fixed investment, you'd take the proportion of working capital increase to sales increases times the forecasted sales amount. Then, it's simply using it. $$\displaystyle \mbox{FCFF} = \mbox{EBIT} \times (1- \mbox{Tax Rate}) - \mbox{Incremental FC} - \mbox{Incremental WC}$$

Not quite.

That's it!

For FCFE, in addition to assuming fixed and working capital as a percentage of sales, there's also a key assumption to how Kutner would fund the investments in working capital and fixed capital. In order to estimate FCFE, the debt ratio (DR) is assumed to be constant in order to project the funding of net new investments and the increase in working capital. Why is that important?

The available funding for fixed and working capital is based on the historical DR, so it's assumed that Kutner will continue to fund the company in the same way. That means that interest expense shouldn't fluctuate but should remain in proportion to debt and equity levels. Given this assumption, say that Kutner's only noncash charge is depreciation. If that's the case, then FCFE can be computed. $$\displaystyle \mbox{FCFE} = \mbox{NI} - (1 - \mbox{DR})(\mbox{FCInv - Dep}) - (1 - \mbox{DR})(\mbox{WCInv})$$ And you can find net borrowing. $$\displaystyle \mbox{Net Borrowing} = \mbox{DR}(\mbox{FCInv - Dep}) + \mbox{DR}(\mbox{WCInv})$$ But if other noncash charges exist besides depreciation, then the formula will most likely be inaccurate, and a review of Kutner's historical trends, such as CAPEX and sales, would be necessary.

Yes!

That's not it.

To summarize: [[summary]]

FCFF would need to be forecast

Historical information wouldn't capture the new breakthrough

Continue Kutner's growth trend

Change the historical relationships

Require more costs to the manufacturer

Gross profit margin

Debt to assets ratio

After-tax operating margin

Because depreciation represents the investment in growth capital

Because depreciation represents the investment in maintenance capital

Interest expense should fluctuate based on the funding source

The available cash flow to equity providers is based on historical funding

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