**Karnen**

*FCF under Tax and No Tax can’t be the same*

*I prefer*

*Under no Tax*

*FCF = CCF = CFE + CFD*

* *

*Note :*

* *

*FCF = Free Cash Flows*

*CCF = Capital Cash Flows*

*CFE = Cash Flows to Equityholders*

*CFD = Cash Flows to Debtholders*

**Ignacio Velez-Pareja (IVP)**

Of course not

Under Tax

FCF (above) – Corporate Tax + TS = CFE + CFD

Did I say it was the same?

NO

The equilibrium equation for cash flows is CCF or Total Cash Flows = FCF + TS = CFD + CFE. In all cases FCF, CFE are after taxes

FCF comes from EBIT (1-T) always. T could be 0 or >0

**Karnen**

*That is clearer*

*but*

*EBIT (1-T) is not always correct*

*I prefer FCF – Corporate Tax*

*Corporate tax is not necessary EBIT * T*

**IVP**

Sure, EBIT (1-T) is not always correct

**Karnen**

* *

*This is why*

*Under No tax*

*FCF = CCF = CFE + CFD*

*under Tax*

*FCF (under No Tax) – Corporate Tax + TS = CFE + CFD*

*this is what I think it correct*

**IVP**

Listen, I teach all the recipes for CFs. BUT what I also teach and do is to construct the CB and from there I just change the sign to the Net Cash Balance of the modules for debt and equity nd you have the CFD and the CFE. Knowing interest paid (or in general financial expenses), you know TS

**Karnen**

*Totally agree with that*

**IVP**

Not correct – Corporate tax

**Karnen**

*but the way in your book*

*saying under No Tax, the FCF is the ssame like under Tax*

*I don’t think it’s correct*

*FCF (under No tax) – Corporate Tax + TS = CFE + CFD*

**IVP**

Listen, there is a problem with some names in the literature.

First, unlevered value is in reality as if there were no taxes. The issue comes from 1958 M&M. They said the pizza doesn’t change in size whatever the way you divide it. Hence unlevered or unlevered is the same. Later what they said? They said, listen, when taxes the way you divide the pizza is relevant BECAUSE there are TS. Then the difference is in having or not taxes.

Second, it is not – Corporate Taxes. It is minus corporate taxes ON EBIT

FCF is defined as unlevered cash flow. And it is EBIT(1-T) (of course not always correct). Depends on the relation of EBIT and financial expenses

**Karnen**

*I agree with you*

*I guess I got something from your book*

*many standard textbooks didn’t say this unfortunately*

**IVP**

It is not Corporate taxes. It is EBIT after corporate taxes and adjust it by investment working capital etc

**Karnen**

*Yes*

*however, in your book as you use FCF*

**IVP**

** **

Then what is the problem?

we don’t use FCF

**Karnen**

*I read chapter 1 or 2 where you gave the expression *

*under no Tax*

*FCF = CFE + CFD = CCF*

*under Tax*

*FCF + TS = CFE + CFD*

*this could confuse the readers*

*FCF from the above two equations are not the same*

*FCF under Tax = FCF under No Tax minus Corporate Tax*

**IVP**

Well, it is understood that FCF in the first case is with no tax and the second FCF is under tax

no tax

of course they are different

you might be interested in this paper: http://papers.ssrn.com/abstract=1604082

IN short: all variables the same with no taxes FCF = CFE+ CFD. With taxes FCF = CFD+ CFE – TS. You are concerned with FCF equal or not. However, the same has to be said for CFE.

**Karnen**

*Under “Tax”, FCF should be less as there is outflows to Tax Office,
though with the presence of the Debt, this tax liability is not that
high, since there is a tax shield from interest deduction.*

What do you think?

**IVP**

Probably the basic idea is there and you have read that before under not taxes CFE is different from CFE with taxes. That is obvious

agree?

**Karnen**

*Yes thanks for bringing this to me*

*many things that I don’t find in the standard book*

*I believe unless they read your book or papers*

*not many finance people have this understanding*

*even though they are finance professors*

*even M&M*

*but yeah…M&M is the first bringing this to light*

**IVP**

sure!!

See how getting the CFs from the CB! How easy is getting

As I told you we have developed a methodology to help the reader on linking the forecasted data to the ongoing firm’s Financial Statements. The basic idea is to solve every mismatch at the time it appears and not letting mismatches to accumulate.

**Karnen**

*By the way, I am now on page 97. My comments, the book doesn’t always use consistent terms and what it is really meant. For example, CRO is in deed cash and cash equivalents, yet this cash and cash equivalents as we know include as well excess funds placed at less than 3 months’ time deposits. So it is not really purely Cash Required for Operations. The book’s approach is to come up first with the projected (assumed) CRO change and ultimately Cumulative Cash Balance at end of year. However, from outside, it is not too easy to get the ideas about how much cash balance in the balance sheet that is really needed to be kept for operations. I guess it is mainly because as analyst, we don’t always the luxury to access this information and by only have one balance at one point of time once in one year, it will be almost impossible to be sure about the operating cash.*

“That chapter is also using marketable securities and short-term investments, but have no explanation what is the difference.” but I think I answered it.”

**IVP**

I see you are very fond of our approach to explain traditional WACC and Ke (and other non traditional approaches).

Well, in fact, CRO is cash in hand. It doesn’t include quasi cash items (read this a short term investments and similar). In practice what I do for this, is to define a policy of maintaining cash in hand. That policy arises either from firm’s or industry’s historical financial statements as a % of some item say expenses, or sales (policy = Cash in hand/Sales, for instance).

In our model, we use in fact the pecking order approach. This is that when we require funds for an investment, we start using the internally generated cash (this is Module 1 (Operating module) where we have inflows from sales and AR minus any payment for purchases in cash and/or AP, plus income taxes.”. Didn’t I? Let me see if there is something additional…

I guess this is one. I have not answered it. I will.

*Karnen*

* *

*I just finished reading chapter 6 The Derivation on Cash Flow. One small comment, even though that chapter gave a lot of detailed reconciliation among many numbers of EBIT, NI, CB, Total FCF, Operating FCF, Total CCF, Operating CCF, etc, etc, yet I don’t see any suggestion about which FCF or CCF the author is to use. I guess it might confuse the readers. It seems to me, the favorite one for Authors is CFD +CFE taken from CB.*

*Back to this Operating and Non-Operating of CCF and FCF, I guess the authors want to show that in valuation context, Operating CCF or FCF excluding the change in marketable securities is the one to use. If that’s the case I agree, since in my practice I took out time deposits of more than 3 months’ due and other marketable securities from FCF, and add them up onto the Enterprise Value, which means we don’t have to value them. We took their face value as of valuation date. In certain exercise, I read other book, the analyst even took out the cash on hand and in banks (probably because the analyst finds it relatively difficult to split the portion belonged to operations and non operations (excess cash that is temporarily being kept at bank). However, I guess, your point is we need to value separately marketable securities or any excess cash as they earn interest rate different (mostly lower) than cost of capital.*

**IVP**

Well, the first question is about how to calculate FCF. We show, the traditional methods starting from, say, EBIT or NI. From CB what we do is FCF = CCF-TS= CFD + CFE – TS. TS IS NOT included in the CB. It has to be calculated with a formula that covers the three cases we have discussed months ago.

This is

case a) EBIT+OI > Fin Expenses (FE) TS = Tx*FE. Case b) 0<EBIT< Fin Exp TS= Tx*EBIT and c) EBIT<0. TS=0.

case b) might be frequent in startups and even in ongoing concerns. There is a compact Excel formula to take account of ANY of the three cases.

The minus sign i FCF = CFD + CFE – TS is because FCF has no TS effects, it is unlevered (this is a misnomer, because it should be named as with no TS effects.. and as you can see, the equilibrium equation (that comes from M&M) says FCF + TS = CFD + CFE.

The xls formula for TS is =Max (T*Min(EBIT+OI;FE);0)

All variables come from the Income statement. I prefer to define FE and not Interest because there are financial expenses different from interest or, in general, not linked to Kd. For instance losses in exchange, bank commissions, Inflation adjustments to financial statements. Even it could be some deductions on dividends paid as it happens in Brazil. They can deduct a % on dividends paid.

**Karnen**

*Ku is the better way in doing that, no circular and TS could be addressed separately. The key issue is how to get this Ku? Do you have the paper showing us as to how to derive implicitly this Ku from the market or public data. Pls don’t tell me we could have this Ku by doing interview with the market participants (big smile). You could download Pepperdine University Research Report to see the research on cost of capital for private markets. I am a bit worried that with all so many valuation books, at the end of the day, all we need to do is just conducting questionnaire, survey, etc to obtain cost of capital. What a waste of time in reading all those books.*

**IVP**

Thanks for your comments.

Two issues: circularity and direct method to get Ku.

Assuming Ku as discount rate for TS does not grant absence of circularity. Circularity exists on methods that use CFE and Ke and FCF and WACC for the FCF. The methods with no circularity are CCF and APV. Also, with Ke as discount rate for TS you can get a method without circularity.

The issue of Ku. This is a promising area of research. As you let me know years ago, there are some work for that applied to non-traded firms. Remember?

Meanwhile, what I usually do is to rely on Bu estimated by Damodaran unlevering levered beta for traded firms. In this case, I “validate” Bu and/or Ku, yes, interviewing the specific investor (in the case of a non-traded firm).

I think there is a lot of work to be done in this area.

The problem is to properly asses the Ku !!! That is it!

On the other hand, as ALL methods result in the same value, given a discount rate for TS, the conclusion is very simple: use the easiest and simplest method or formula (non circular). In other words, there is no such thing as the best method for valuing X, Y or Z type of firms! All methods are good for ANY firm.

Additionally, it is important to note what are TS about and what are TS for.

I don’t remember if we presented there the idea of three pieces formula for TS. This is,

- TS = T*FE if Ebit + OI > FE
- TS = T*Ebit+OI if Ebit + <FE but >0
- TS = 0 if Ebit+OI <0

TS = Tax Shield

T = Tax rate

FE = Financial Expenses (net of Interest Income)

OI = Other Income

EBIT = Earnings Before Interest and [Corporate Income] Tax

The other idea you should stress is that thinking on TS as KdDT is an over simplification. TS might be generated by other sources different from Kd. For instance, Losses in exchange rate when you have debt in FX. For that reason I use FE financial expenses, in the above three-pieces formula and not KdTD.

**Karnen**

On potential dividends, I guess I agree with your ideas, this potentially increases the FCF and the calculated value. One question, if you take out from FCF for those cash and quasi cash being kept temporarily at Balance Sheet, I believe we need to value it separately from, let’s say, cost of funding capital, instead apply the interest rate that the company could earn at the going market rate. Agree?

**IVP**

The issue is this, when you have your model, eventually you have excess cash that you invest at short term. This clearly has a poor return and that “penalizes” cash flows. When you have the N CFs, at the end you include a Terminal Value calculated somehow with a perpetuity. But that is not all you have at time N. At N you recover what I call trapped cash. Trapped cash is the result of taking the cash and quasi cash items plus AR discounted at the discount rate minus AP discounted as well. This becomes what I call the Adjusted TV that is composed, as said, of the perpetuity plus the trapped cash (I know that trapped cash has a different meaning as seen at https://www.treasurers.org/node/8474) but that is literarily the name we have in Spanish.

The short-term funds usually earn much less that the cost of capital due to the low risk it has; however, it should be penalized discounting the returns at your cost of money. In fact, ANY stockholder might claim not to invest at low rate but distribute it to owners. As it is not distributed, that is a loss that should be reflected discounting the CFs from that bad investment. Assuming Potential Dividends is a fiction because you in fact, don’t distribute it and yet you keep it invested in Certificates of Deposit or similar. Follow?

**Karnen**

Could you kindly elaborate this:

*But that is not all you have at time N. At N you recover what I call trapped cash. Trapped cash is the result of taking the cash and quasicash items plus AR discounted at the discount rate minus AP discounted as well. This becomes what I call the Adjusted TV….*

**IVP**

**NOPLAT**and assumes that ALL generated operating cash will be available from N+1 and on. HOWEVER, a real firm, has AR, AP to be received and paid say, at N+1 plus cash or quasi cash that you have in hand. If you disregard this you have some value lost: the cash in hand, the AR and AP (net) at N+1. You will agree that leaving those funds in the BS they will vanish! They are not captured by the CFs. Hence, what we do is to recover any cash or quasi cash we show in the BS, assume that AR and AP will be received/paid on N+1, hence, we discount them at WACC. This is what I call trapped cash. As AR and AP will be received/paid at N+1, what I do is to discount them at the WACC and add the result to the perpetuity.

**Karnen**

How to take out that trapped cash from TV. I guess, the key is lying on the FCF

TV is built in many formulas on the FCF_t

Need to be careful on that, not to include trapped cash

Is that what you are saying, right?

**IVP**

Yes. The FCF does not have AR and AP from year N included. Follow?

**Karnen**

AR and AP is part of the working capital. How come we took them out?

Excess cash, yes, I agreed, they are to be excluded but not AP and AR

Business relies on the AR and AP, the “bread”, excess cash is the ‘butter’.

**IVP**

Wait. I follow the idea of Copeland (Valuation textbook). TV = NOPLAT_n(1+G)(1-g/ku)/(WACC-G)

Answer this question: Are AR and AP included in FCF_N?

**Karnen**

Yes, of course, we can’t have FCF without those two very critical ingredients.

**IVP**

Ok. Then ask this one: When using NOPLAT_N or FCF_N in the TV Formula, do they have the AR and AP from N?

Do they? Explain how FCF_N includes AR and AP at N.

**Karnen**

The movement of AR and AP to come up with the cash flow, I am talking about “stock” but “flow” because only through the “flow” we could get the estimated FCF.

**IVP**

The AR and AP ARE NOT in the FCF!!! They are not received but until next period by definition

Have you received AR and AP from N at N?

Do we agree that with FCF_N we leave out AR_N and AP_N? Again: you have your BS at N. That includes AR_ and AP_N agree?

**Karnen**

How much big? FCF will come, FCF is the result, AR and AP is the ingredient.

In the extreme way, talking about perpetuity, I don’t care about AR and AP whether be part of FCF or not

It will be somehow realized to cash someday sooner or later

In finite cash flow context, yes, we care about the timing of the cash stream coming to the company pocket, but in perpetuity, it’s very different story.

**IVP**

Yes, but the idea in the indirect method is no eliminate all the elements that are not or should not be included in the FCF. When you subtract the change in WC what you did is to recover the AR and AP from N -1 and leave in the BS the AR_N and the AP_N.

**Karnen**

TV is at the end of 5th year, 10th year? Many valuation analysts put TV “too quick”

**IVP**

Wait. We have to clarify the ideas of what happens with AR and AP at N.

TV is the value of firm at N.

**Karnen**

But TV could be anything, we even could use whatever formula we want to see, EBITDA multiple, FCF multiples.

**IVP **

Do we agree that AP and AR from N are in the BS of N and not recovered with FCF_N?

[Using] Multiples are challenging.

**Karnen**

TV could be whatever concept we want to put there, liquidation, sustaining value.

AP and AR at end of projection formula, they are supposed to be sitting at Balance Sheet_N.

**IVP**

** **

Ok, let be clear about what happens with AP and AR at N. If you use liquidation value at N then you recover your trapped cash.

Let’s do the TV as a perpetuity. Agree?

**Karnen**

Yes, in M&A – the seller will say, and could treat AR and AP as “cash”. It means the seller will consider AR is “cash”, they want the buyer to pay that, net of AP of course. In that means at N, we could treat AP and AR as “cash”, or whatever you name it.

The seller and buyer want to put “cash” on that, you follow me?

AR = “cash” to receipt.

AP = “cash” to pay.

**IVP**

When you calculate the WC you don’t consider AR as cash.

**Karnen**

Both we could treat as “cash”, though sitting on the Balance Sheet, but from the M&A perspective.

**IVP**

Ok cash BUT at period N+1.

**Karnen**

They are “cash”, the seller/buyer want both (AR and AP) be considered in the price. Assume no AP, then

the price + AR.

**IVP**

They are AR, not cash. Cash is what you have in hands and/or in a Short-term investment.

**Karnen**

Because the seller knows in advance, the AR collection will come as cash to the buyer’s pocket once they signed the M&A, so AR = cash at terminal value.

Under finite stream of cash, this is different.

**IVP**

Ok. That is what we assume that happens to calculate the trapped cash. Only that I recognize that it is cash to be received at N+1.

**Karnen**

This is why I agree with your finite concept, that trapped cash in the perpetuity concept, not necessarily N+1.

**IVP**

That is the reason I adjust the AR by a discount factor.

**Karnen**

From the seller’s perspective, they could collect from the buyer, earlier even. We don’t even need discount rate, to assume AR = Cash on N+1.

**IVP**

Under normal conditions, you collect AR when they are due. Usually next period.

**Karnen**

But on TV?

**IVP**

On TV, there are not AR.

**Karnen**

The seller wants to collect/pocket it quicker, not N+1. The collection comes from the buyer’s money.

AR could be on average only [extendable] 30 days, not one year.

**IVP**

Sure but you can’t request the customer to pay now after he has had a term to pay later.

**Karnen**

Or even due within 1 day, if the buyer is the customer itself.

**IVP**

Ok, then change the period to months. No problem. All my valuations are done on a monthly basis. The problem is the same.

**Karnen**

The seller-buyer treats AR as “cash” on the terminal value.

**IVP**

Wait and explain. You are saying that a firm has some AR.

**Karnen**

Theoretically I am nodding my head in agreement with you, but in reality, talking about TV I meant, AR could be seen as “immediate cash” for the seller, not necessarily N+1.

You limit your analysis to normal condition, but in reality, once in M&A world, normality is an exception.

**IVP**

** **

And the firm is merged or sold. Hence the new owner goes to the customer and says, “*Well I am the new owner and I demand you to pay immediately your AP with my firm. The customer will answer: NO: I have been given a term of 30-60 days, whatever to pay and I will stick to it.*”

**Karnen**

The seller wants to pocket the money as quickly as possible, since they are going to lose the control immediately.

**IVP**

Explain how is it managed with the customer?

**Karnen**

Again, as I said, customer could be the buyer itself. You need to be clear in your analysis, in the case the buyer is the customer.

**IVP**

That is a special case. Forget that, take a more general example.

**Karnen**

No 30 days, but in TV again, it is all about negotiation.

[Under] Finite, it’s a bit different.

**IVP**

Ok fine. If that is the situation, you have the cash immediately at N (240 months from today).

**Karnen**

TV – we could put whatever both parties agree to put there.

**IVP**

Of course.

**Karnen**

Again, EBITDA multiple, EBITDAR multiples, etc.

**IVP**

Are we discussing general cases or specific cases?

**Karnen**

FCF, whatever, or even they could just grab the number from thin air.

AR = cash for the seller. They don’t even care whether the buyer will collect within 30 days or more

Follow? Negotiation could be a nasty thing, the seller wants to pocket something as quickly as possible.

**IVP**

Listen, when you model a situation you include whatever you think it is going to happens. If you say that AR will be collected immediately, then we can model that and no problem.

**Karnen**

TV is not easy to put a formula on that, we could come with very elegant formula.

if we can have one formula, life will be much easy for everybody, seller and buyer.

TV, I am going to go to sleep, if somebody tells me about TV. I like it when you said TV is a bit problematic.

**IVP**

Listen, when I teach this I get embarrassed because I do a lot of efforts in forecasting the financial statements and I have to end with a gross approximation such as the TV. Usually I use three estimates of TV:

1) liquidation value,

2) non-growing perpetuity and

3) growing perpetuity.

**Karnen**

Other than those 3 formulas, there are out there many formulas, even something that is not making sense.

Many M&A failed creating value, because it is so hard to define TV, please read the books on why M&A failed, too expensive price.

**IVP**

Even you can use that questionable TV to fix a pre-defined value of firm if you wish.

**Karnen**

Too much “goodwill”, this is because awfully difficult to say which TV is correct.

No good formula for TV. This is my conclusion so far, still a black and red box to me.

**IVP**

I give a **** for TV as a perpetuity.

**Karnen**

We could put into that box whatever we want, TV 80% – 90% of the value, very hard to believe.

**IVP**

Listen you are assuming CONSTANT inputs for perpetuities. THAT is similar to the questionable multiples.

**Karnen**

Yes..yes…, time constant rate of return, but everybody use that.

**IVP**

Usually I try that TV is not more than 25% – 30% of total value.

**Karnen**

TV is an elusive concept.

**IVP**

I say that and I say that in my courses. I tell my students listen, I am ashamed to arrive to this issue. We have been working hard to make the forecasting of financial statements and sharpening the pencil to put the better numbers as inputs to end with a questionable perpetuity.

**Karnen**

We must project the CF for into 30 years, sounds a “voodoo” to me, not an analyst.

**IVP**

Sure.

**Karnen**

A voodoo analyst.

**IVP**

Sure.

Bottom line: we agree that TV is a mess. TVs as perpetuities are a mess. No TV is nonsense, then what to put at N as value of the firm=? I have NFI.

**Karnen**

Use many formulas, that’s my suggestion, no single formula fits all sizes, all might be justifiably correct.

The seller in my experience, will pick up the highest value, and the buyer will pick up the lowest, that’s reality!

**Ignacio Velez Pareja**

This is my short criticism to the TV:

“** The calculation of the terminal value is a very risky exercise since it requires making very strong assumptions and a very simple tool is used for its calculation. However, experience indicates that this terminal value is often what defines whether a project is good or not. Some (including the authors) have observed that this terminal value can account for more than half of the present value of the flow of a project. It depends on the number of periods in the projection. This is understandable, because for a greater number of years in the projection, the relative value of the TV loses importance when discounting it to the period zero.**”

What do you think? Is it strong enough? Does it reflect my position posed yesterday?

*Jakarta, Jan-Feb 2017*