FCF adjustment for debt

[Packer16]

I have been trying to develop an adjustment to FCF for higher levels of debt.  I would like to hear how others deal with leveraged firms and comments on this adjustment methodology.  The method is to estimate the time it will take the firm to reduce its leverage to 3.0x EBITDA (a typical benchmark for Templeton) using FCF.  Develop a discount factor for FCF as 1/(1.1)^(# of years calculated) and apply to all firms with debt > EBITDA*3.0.  This allows for an apples to apples comparison of FCF for both levered and not so levered firms in the same industry.  TIA

 

Packer

[Rabbitisrich]

Are you reducing principal for debt in which the costs exceed the WACC? In that case you might consider the principal reduction as an investment, in which case you wouldn't make an adjustment to FCF. If the debt cost is below WACC, then you are making a principal reduction for balance sheet or contract purposes, i.e. you are forced to make the payments. In that case, you should reduce the FCF by the principal payments since those monies are not unencumbered.

[Packer16]

The cost of debt is below the WACC.  I am just reducing the debt to a conservative level under the assumption the FCF is not really the equity holders until they reduce the principle to the point where they can distribute the FCF without the say of the debt holders.  The conservative level is the level they could easily re-finance even under difficult economic circumstances.

 

Packer

[Rabbitisrich]

Packer16, did you come to a conclusion regarding the treatment of FCF for companies with a high debt load?

 

I take a simple approach based upon management's intentions.

 

If management intends to reduce debt:

1. If debt above WACC--or my estimate of required return--then treat as an investment with no adjustment to FCF (I use owner's earnings).

2. If debt below WACC, then deduct the principal reduction from FCF.

 

If management is ambiguous or does not intend to reduce debt:

1. Add a risk premium to required return.

2. Pray.

 

The first situation tends to overstate the value since I don't make an adjustment to required return while the company is paying down the debt. The second method will increasingly undervalue the company assuming that asset growth outpaces debt.

 

I'd be interested if you find a better method.