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Power plants company: Free Cash Flow?

I have a consolidated power company model that has current operational power plants and plants under construction. I’m using FCFF in valuing both types so far. But I think it is wrong to use FCFF for a project that has not yet started because I am not taking into account the debt in the future. Ho... Read More

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by Guest 1.

added 11 years ago

Re: Power plants company: Free Cash Flow?

If you’re doing a NAV calculation, which it looks like you are, then I would agree to use FCFE because this is the “net” cash flow after tax that the company receives. This falls under a sum-of-parts valuation in which you add up the value of each asset on an equity value basis, after the spec... If you’re doing a NAV calculation, which it looks like you are, then I would agree to use FCFE because this is the “net” cash flow after tax that the company receives. This falls under a sum-of-parts valuation in which you add up the value of each asset on an equity value basis, after the specific asset’s debt load.

FCFF as discussed in class refers to company valuation. So in that context you take the total FCFF of the entire company (which is really the sum of each asset’s FCFF, but you are getting FCFF off financial statements as opposed to each asset’s P&L) and then you apply DCF to get TEV, minus net debt, etc. If you recall I said we generally don’t like FCFE because of the ability to manipulate your net borrowings and thus, alter the value arbitrarily. However, in the case of project finance (power plants and mines for sure), the debt changes (amortization) is usually predetermined and doesn’t change, so the ability to manipulate the numbers is not there.

This is a similar concept in real estate. Value the entire company based on company cash flows vs. NAV build-up of each property after debt load per property. You are currently doing the NAV of each asset and the debt structure of these pre-existing assets won’t change or is pre-determined, so FCFE would be correct in this context. However, for DCF of entire company, you want to use FCFF for sure and then minus out net debt. Let me know if that distinction is clear. In class, we were referring to company value not per asset value.

For future projects that have not yet come online, the question of FCFE vs FCFF boils down to whether or not the debt funding is in place yet. Your concern of not taking into account debt in the future is correct – because you are supposed to. remember, it’s always FCFF, then discount to get TEV minus net debt. The ONLY time FCFE and FCFF will yield the same numbers is when the interest rate, earnings yield AND the wacc are all the same. (review the Share Repurchase video in your WST login).

So to answer your question, I would do the following for future projects: use FCFF. And then assume an average debt/capitalization ratio and subtract that out. So if your UNLEVERED value (using FCFF) is $100 and the average debt load is 30% debt/capital, you can assume $30 of debt, so equity value is $70. This is because you don’t want to get caught (trapped) making assumptions on interest rates that you don’t know yet. Otherwise, you may continue to use FCFE, but you have to assume interest rates and of course, you still need the assume debt level per project.

As I skim through you model though, I see inconsistencies in each plant though. So if I look at your EXISTING plants, sometimes you do equity value off NOPAT and then sometimes TEV off FCF and then minus net debt. Since you’re doing an NAV build-up of each plant, I would just calculate FCFE for each and discount that. add them up as you have it on NAV tab and minus out corporate/parent debt as you did. don’t double count - i.e. b/c you took out interest on per asset basis (hence FCFE), don’t include those asset specific debt that already reduced cash flow.

Let me know if that clears things up. Read More

by WST Expert 1.

added 11 years ago

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