Free Cash Flow – FCFF

Part 2 – What is Free Cash Flows (FCFF)

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

 

Excess-Cash

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One should think of 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.

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.

Technical Calculation of Free Cash Flows

Computations of FCFF

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 The above formula is mostly used by analyst. Other formulas of Free Cash Flow to Firm(FCFF) are as per below.

FCFF Formula

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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

 

Free Cash Flow - Non-Cash Items

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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
  • 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

 Calculate the FCFF for 2008 in the following example?

 Free Cash Flow to Firm Example

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Solutions

Please note: FCFF using all three formulas comes to the same number

 

How to calculate FCFF FCFF analysis

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Part 1      Discounted Cash Flow
Part 2      Free Cash Flow
Part 3      Discounted Cash Flow Analysis
Part 4      Working Capital
Part 5      Terminal Value
Part 6      Capital Structure
Part 7      Convertible Bonds
Part 8      Stock Options
Part 9      WACC
Part 10   Cost of Equity
Part 11    CAPM
Part 12    What is BETA
Part 13    Unlevered beta and Levered beta
Part 14    market risk premium
Part 15    Enterprise Value
Part 16    Equity Value
Part 17    Summary of DCF

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