glsy
April 27, 2024, 7:48am
#1
Hello folks,

I am reading about the Capitalized Cash Flow Method (“CCM”) in a textbook which says this:

Can someone help me understand:

Economically, why is reinvestment rate = g / WACC ?
In the formula for value of a firm, how do we correlate EBIT1*(1-T)*(1-b) to FCFF1 ? I can’t see the equivalence
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.

MikeyF
April 28, 2024, 1:40pm
#3
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.

glsy
April 28, 2024, 2:30pm
#4