Free Cash Flow

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DCF valuation focuses on the cash flows generated by one part of the business – the Operating Assets.

One should think of Free Cash Flow to Firm (FCFF) from the accounting cash flow perspective. The cash flow that is generated from the business is termed as cash flow from “Operations”, and the cash flows that are invested in the business is known as “cash flow from investments”. Broadly, the definition of  FCFF is the Net of Cash Flows from Operations and Cash Flows from Investments.

Free Cash Flow to Firm (FCFF) = Cashflows from operations (CFO) + Cashflows from Investments (CFI)

A business generates cash through its daily operations of supplying and selling goods or services. Some of the cash has to go back into the business to renew fixed assets and support working capital. If the business is doing well, it should generate cash over and above these requirements. Any extra cash is free to go to the debt and equity holders. The extra cash is known as Free Cash Flows.

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 The above formula is mostly used by an analyst. Other Free Cash Flow to Firm formula is as per below.

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Detailed Explanation of FCFF Line Items

Net Income

• Net income is taken directly from the Income statement.
• It represents the income available to shareholder’s after taxes, depreciation, amortization, interest expenses and the payment to preferred dividends

Non Cash Charges

• Non-cash charges are items that affect net income but do not involve the payment of cash.
• Some of the common non-cash items are listed below

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After tax Interest

• Since interest is tax deductible, after-tax interest is added back to the net income
• Interest cost is a cash flow to one of the stakeholder’s of the firm (debt holders) and hence, it forms a part of FCFF

 Capital Expenditure

• Investment in fixed assets is the cash outflow required for the company to maintain and grow its operations
• It is possible that a company acquires assets without expending cash by using stock or debt
• An analyst should review the footnotes, as these asset acquisitions may not have used cash in the past, but may affect the forecast of future Free Cash Flow to Firm (FCFF)

 Change in Working Capital

•  The working capital changes that affect Free Cash Flow to Firm (FCFF) are items such as Inventories, Accounts Receivables, and Accounts Payable. This definition of working capital excludes cash and cash equivalents and short-term debt (notes payable and the current portion of long-term debt payable).
• Do not include non-operating current assets and liabilities, e.g. dividends payable etc

 Basic Example of FCFF (Free Cash Flow to Firm)

 Calculate the FCFF for 2008 in the following example?

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Solutions

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