The Free Cashflow to Firm Two Stage Model is a DCF model that is used by finance professionals across the world to sum up the present value of FCFF in a high growth phase and stable growth phase. The valuation uses the Working Average Cost of Capital (WACC) and an assumed stable growth rate (g) to discount free cashflows to a firm. The FCFF Two Stage Model is similar to the FCFE Two Stage Model, however debt is treated differently in the FCFF Two Stage Model.
The FCFF Two Stage model is a type of Dividend Discount Model (DDM) valuation, taking into consideration growth and other factors to discount future cashflows and give investors a better picture of a firm to determine how attractive it may be for investment. Using the variables below, the FCFF value of a firm can be calculated easily by investors to aid in making investment decisions.
The Working Average Cost of Capital (WACC), often also referred to as the Weighted Average Cost of Capital, is the percentage rate of return a business needs to generate in order to compensate, on average, both the debt and equity capital providers to the business. The WACC of a firm can be calculated as follows:
WACC = (w (E) * r (E) ) + (w (D) * r (D) *(1-tax rate) )
Where w is the weight of debt or equity, r is the rate of return on debt or equity, D is the value of debt, E is the value of equity, and the tax rate is the rate of tax the company pays.
The final growth rate that the firm reaches once reaching a maturity stage in its growth cycle. This value of growth is assumed to apply to future FCFF values after erratic growth has settled.
Free Cashflow to Firm in period t. In this formula, the period “t” can be any number of periods before a firm reaches maturity, in which it is assumed that payments will grow by a stable growth rate indefinitely.
The number of periods is the number of unstable growth periods before a firm reaches maturity and achieves a stable state of growth.
This is the final period of unstable growth before stable growth is reached. For example, a firm that has 7 values for unstable FCFF before reaching a stable growth period would have an n value of 7, with the value of FCFF after this final period being the first value for stable growth, as explained below.
The first value of stable growth after period “n”, “n” being the last period of unstable growth. This value is used to calculate the value of a firm indefinitely using the standard DDM calculation, as depicted in the formula above.
The present value of a firm to an investor, calculated with the Free Cashflow to Firm Two Stage Model. This value is used by investors to determine whether a firm is viable for investment and thus influences investor decisions. It can be used to compare to other firms within the industry as a form of valuation, or to compare a firm to previous years of its operation in order to measure performance.
Assume a company is going through a growth stage lasting 4 periods, reaching maturity in its fifth period. In order, the company makes cashflows of $5,000,000 in period 1, $6,500,000 in period 2, $4,750,000 in period 3, $6,000,000 in period 4, and $3,950,000 in period 5 which is the first period of stable growth. After the fourth period the company is assumed to reach maturity and achieve stable growth for every period after, making the FCFF value in period 5 the first payment of stable growth FCFF value (FCFFn+1. The stable growth rate for the company is 5% and the working average cost of capital (WACC) is 12%. Using the FCFF Two Stage Model, the value for the company can be calculated as follows:
V = Σ(FCFFt / (1+WACC)t) + (FCFFn+1 / (WACC–g)) / (1+WACC)n
V = (5,000,000 / (1+0.12)1) + (6,500,000 / (1+0.12)2) + (4,750,000 / (1+0.12)3) + (6,000,000 / (1+0.12)4) + (3,950,000 / (0.12–0.05)) / (1+0.12)5
V = $52,701,487,85
Using the FCFF 2 Stage Model formula, the value of the company today is $52,701,487.85. This value can be used by investors to determine whether to invest in a company by comparing the value to other companies within an industry or market, or used as a comparative to past performance of the same firm.
The advantage of FCFF over other cash flow concepts is that they can be used directly in a DCF framework to value the firm. These measures do not account for the reinvestment of cash flows that the company makes in capital assets and working capital to maintain or maximize the long run value of the firm.
The FCFF Two Stage Model allows investors to make more informed decisions on whether to invest or divest in a company by providing an easily interpreted value for free cashflows to the firm. The FCFF value calculated can be used to determine whether a company is prospering or investing capital well.
The FCFF Two Stage Model can be used to value companies where the first stage has an unstable initial growth rate and there is stable growth in the second stage, which lasts forever. The first stage may have a positive, negative, or volatile growth rate and will last for a finite period, whereas the second stage is assumed to have a stable growth rate for the rest of the life of the company. Investors can use the value of the FCFF Two Stage Model to determine whether a company is going to be prosperous or performing well, using this information to make informed investment decisions.
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