The Free cash flow to equity model to a financial corporation is defined as the amount of cash that is available to equity shareholders, once all financial obligations are met; the latter of which includes debt payments, capital expenditure and also working capital needs ( Parameswaran, 2011 ). The free cash flow to equity model is used by financial analysts as a tool for determining the value of a firm.
The corporate free cash flow model is used as a measure of an entity`s financial performance. This is achieved by deducting the capital expenditure from the operating cash flow ( Bragg, 2007 ). In a situation whereby the Company spends the money that had been reserved for expansion the amount of money it is able to generate is actually the corporate free cash flow.
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The adjusted present value is defined as the net present value of a particular project in an instance such that it is financed solely by equity in addition to the value placed on financial benefits ( Parameswaran, 2011 ).
Differences
In the corporate free cash flow model, the cash flow is discounted on the weighted average cost of capital (WACC) ( Parameswaran, 2011 ). The costs of equity and debt are combined in the same proportions that were used by the firm. Conversely, the free cash flow to equity model is discounted at a specific rate that reflects the level of risk in the equity of shareholders. Since the risk associated with an equity shareholder is much higher than the risk of an entire leveraged firm, the discounting factor is the expected return on equity. The adjusted present value approach on the other hand makes use of the cost of equity as the discount rate as opposed to the WACC ( Bragg, 2007 ). This means that it does not include taxes and other financial effects in a WACC.
Strengths and Weaknesses
The main strength of the free cash flow to equity model is that it offers a sound valuation method that eliminates any subjective a ccounting policies ( Parameswaran, 2011 ). The disadvantage is that it mainly depends on the assumptions and forecasts that are made by a financial analyst. This means that small adjustments may cause it to vary substantially. The corporate free cash flow model on the other hand allows investors to make better decisions for a company by providing a close and intrinsic stock value ( Bragg, 2007 ). The downside is that it only functions accurately based on the assumptions and forecasts that have been made. Conversely, the APV approach can be used to evaluate any type of financial package. Its main weakness is that it ignores tax exhaustion, bankruptcy risk and agency costs.
The main similarity of these approaches is that they are all used as a measure of a company’s financial performance. They enable a company to evaluate its performance and develop methods of improving the cash flow models to increase its value.
References
Bragg, S. M. (2007). Financial Analysis: A Controller's Guide . Chichester: Wiley.
Parameswaran, S. (2011). Fundamentals of Financial Instruments: An Introduction to Stocks, Bonds, Foreign Exchange,and Derivatives . Chichester: Wiley.
