Hello folks,
I am reading about the Capitalized Cash Flow Method (“CCM”) in a textbook which says this:
Can someone help me understand:
Thanks!
WACC is kind of the rate the firm earns from the market. And g is kind of the proportion of wacc kept back in the business. Thus, retention ratio is g/wacc.
As the picture shows after-tax EBIT (which is EBIT*(1-T)) adjusted for reinvestment in fixed and working capital ( multiplying 1-b) is often used as a proxy for FCFF.
I think it easier to think about the formulas with equity as we know theses already.
We have growth = ROE x retention rate. This just mathemtically derived assuming ROE remains the same on re-invested capital.
g = ROE x b
or re-arranged
b = g / ROE
The above just does this at the firm level think about WACC and firm value
g = WACC x reinvestment rate
reinvestment rate = g / WACC
EBIT1*(1-T)*(1-b) = money not re-invested in the firm
The equivalnet to dividends in the
Price = D1 / (Re - g)
Price = earnings x payout ratio / (re - g)
Price = earnings x (1 - b) / (re- g)
The formulas in your text take this same approach but are doing it at the form level.
Remember FCFF is after capital investment
FCFF = CFO - CFI + change in Debt
FCFF is the surplus cash from after re-investment.
