Wednesday, October 05, 2011

Free Cash Flow

CFA Level 1 - Financial Statements

Free Cash Flow (FCF)
Free cash flow (FCF) is the amount of cash that a company has left over after it has paid all of its expenses, including net capital expenditures. Net capital expenditures are what a company needs to spend annually to acquire or upgrade physical assets such as buildings and machinery to keep operating.

                                                      Formula 6.12

Free cash flow = cash flow from operating activities - net capital expenditures (total capital expenditure - after-tax proceeds from sale of assets)

The FCF measure gives investors an idea of a company's ability to pay down debt, increase savings and increase shareholder value, and FCF is used for valuation purposes.

Free Cash Flow to the Firm (FCFF)
Free cash flow to the firm is the cash available to all investors, both equity and debt holders.  It can be calculated using Net Income or Cash Flow from Operations (CFO).
The calculation of FCFF using CFO is similar to the calculation of FCF. Because FCFF is the cash flow allocated to all investors including debt holders, the interest expense which is cash available to debt holders must be added back.  The amount of interest expense that is available is the after-tax portion, which is shown as the interest expense multiplied by 1-tax rate [Int x (1-tax rate)]. .
This makes the calculation of FCFF using CFO equal to:

FCFF = CFO + [Int x (1-tax rate)] – FCInv

CFO = Cash Flow from Operations
Int = Interest Expense
FCInv = Fixed Capital Investment (total capital expenditures)

This formula is different for firm’s that follow IFRS. Firm’s that follow IFRS would not add back interest since it is recorded as part of financing activities. However, since IFRS allows dividends paid to be part of CFO, the dividends paid would have to be added back.
The calculation using Net Income is similar to the one using CFO except that it includes the items that differentiate Net Income from CFO.  To arrive at the right FCFF, working capital investments must be subtracted and non-cash charges must be added back to produce the following formula:

FCFF = NI + NCC + [Int x (1-tax rate)] – FCInv – WCInv

NI = Net Income
NCC = Non-cash Charges (depreciation and amortization)
Int = Interest Expense
FCInv = Fixed Capital Investment (total capital expenditures)
WCInv = Working Capital Investments
Free Cash Flow to Equity (FCFE), the cash available to stockholders can be derived from FCFF.  FCFE equals FCFF minus the after-tax interest plus any cash from taking on debt (Net Borrowing).  The formula equals:

FCFE = FCFF - [Int x (1-tax rate)] + Net Borrowing

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