In this current exercise we are really only interested in assessing the intrinsic value of IBM stock not the company as a whole.  As a result, we next make adjustments for the fact that IBM’s assets are funded using both debt and equity.  Thus we need to make additional adjustments to take into account that some of the Capital Expenditure (CAPEX) is funded by debt-holders.  Again as a first pass we will make a simplifying assumption.

Adjusting a Stock’s CAPEX:  

The objective of this part is to assess the proportion of Capital Expenditure (CAPEX) that is financed by debt-holders in the firm. 

Recall, from section 3 that FCFE was defined as:

FCFE = FCFF – Interest*(1 – Tax Rate) + Net Borrowing

For valuation purposes the analyst is left with the problem of forecasting what the future Net Borrowing needs of the firm are.  There are several approaches that can be taken.  First, an analyst may analyze in detail the firm’s financing decision over a long enough period of time to cover a complete business cycle and then compute average net borrowing numbers.  Alternatively, an analyst may project future net borrowing needs by estimating some target debt ratio that is applicable to the firm and or its industry.  That is, if the debt ratio remains approximately constant over time then this implies that the debt-holders fund some constant proportion of capital expenditures over time.  Under this latter assumption the adjustment is the following:

Free Cash Flow to Equity = Free Cash Flow to the Firm – Interest*(1-Tax Rate) + Capital Expenditures * (Debt Ratio)                                                                                                      2)                                                             

Notice by substituting in equation 1) above into the “Free Cash Flow to the Firm” in equation 2) this is equivalent to (interest adjustment is added and subtracted):

Free Cash Flow Equity = Cash Flow from Operations – (1- Debt Ratio)* Capital Expenditures (CAPEX)                                                                                                            3)         

This method adjusts capital expenditures for that part which is permanently financed by debt holders if debt ratios are relatively stable over time (i.e., debt is rolled over).

Note:  The above heuristic does not apply to a financial institution for which the issue of debt is part of their investment as opposed to financing decision.  For example, the above heuristic does not apply to a bank.

We now turn to applying this discussion to calculate the FCFE number for IBM.