Computing FCFF and FCFE

Computing FCFF from Net Income

FCFF is the cash flow available to a firm’s capital providers after deducting operating expenses, working capital expenses, and fixed capital investments.

FCFF can be calculated from net income as:

$$\begin{align*}\text{FCFF}&=\text{Net Income}+\text{Net Non-Cash Charges}+\text{Interest Expense}(1-\text{Tax Rate})\\&-\text{Fixed Capital Investments}-\text{Working Capital Investments}\end{align*}$$

The net income used in the above equation is before the deduction of dividends to common shareholders, assuming the company’s suppliers of capital are bondholders and common shareholders.

Net non-cash charges represent an adjustment for non-cash decreases or increases in net income. An example of a non-cash expense is depreciation and amortization. This is an expense that reduces net income but does not involve a cash outflow. It must therefore be added back to net income when computing FCFF. Information on non-cash charges can be found in the statement of cash flows.

After-tax interest expense must be added back to net income to arrive at FCFF. This is because interest expense is deducted to arrive at net income, but this interest is a cash flow available to the firm’s debt suppliers.

Fixed capital investments represent a cash outflow to purchase fixed capital like property, plant & equipment (PPE) necessary to support a firm’s current and future operations. This information can be derived from the company’s statement of cash flow.

Working capital investments represent net investments in current assets (accounts receivable) less current liabilities (accounts payable) excluding cash and short-term debt (notes payable and current portion of long-term debt). This information can be derived from the balance sheet and statement of cash flow. 

Note: If a firm has preferred stock, preferred dividends are deducted when calculating net income. Therefore, it is added back when calculating a firm’s FCFF because this cash flow is available to another of the firm’s capital providers, preferred stockholders.

Computing FCFF from Cash Flow from Operations

Cash flow from operations (CFO) can also be used to calculate FCFF. CFO is the net amount of cash provided by the company’s operating activities. Cash flow from operations already incorporates adjustments for non-cash expenses (like depreciation and amortization) and net investments in working capital.

The statement of cash flow is broken down into three segments:

1. Cash flow from operating activities: This is the net amount provided by the company’s operating activities.
2. Cash flow from investing activities: This is the use or source of cash from a company’s long-term assets like PP&E.
3. Cash flow from financing activities: This section shows a company’s activities in raising or repaying capital.

FCFF can be estimated from CFO as:

$$\begin{align*}\text{FCFF}&=\text{Cash Flow from Operations}+\text{Interest}(1-\text{Tax Rate})\\&-\text{Fixed Capital Investments}\end{align*}$$

Non-cash charges and working capital investments are not included in the above calculation because they are already included in the calculation of CFO.

Computing FCFE from FCFF

Free cash flow to equity (FCFE) is the cash flow available to equity holders. In contrast, cash flow to the firm (FCFF) is the cash flow available to all the suppliers of a firm’s capital (common shareholders, debt holders, and preferred stockholders, if any). FCFE is the sum that the company can afford to pay out as dividends. Companies, however, do not pay the entire amount because they would like to keep their dividends stable.

Assuming no preferred shareholders, the difference between FCFF and FCFE is the cash flow to the suppliers of debt. The cash flows that arise from transactions with debtors are deducted from FCFF to arrive at FCFE.

FCFE can be calculated as:

$$\begin{align*}\text{FCFE}&=\text{FCFF} -\text{Interest}(1-\text{Tax Rate})\\&+\text{Net Borrowing}\end{align*}$$

After-tax interest is deducted from FCFF to remove the cash flow that is available to debt holders. As a result, net borrowing includes the company’s debt borrowings less debt repayments to arrive at the net amount.

Just like FCFF, FCFE can be calculated from net income and cash flow from operations:

$$\begin{align*}\text{FCFE}&=\text{Net Income}+\text{Non-Cash Charges}-\text{Fixed Capital Investments}\\&-\text{Working Capital Investments}+\text{Net Borrowing}\end{align*}$$

The difference between this equation and the one that calculates FCFF using net income is the after-tax interest and net borrowing. After-tax interest is already deducted in the calculation of net income and is therefore not added back. Net borrowing is added because this amount is available to equity holders to use at their discretion. Thus, it is calculated as the company’s borrowing less the company’s repayments. 

$$\begin{align*}\text{FCFE}&=\text{Cash from Operations}-\text{Fixed Capital Investments}\\&+\text{Net Borrowing}\end{align*}$$

Cash from operations already has adjustments for interest expense and working capital investments. Therefore, deducting fixed capital investments and adding net borrowing to it would estimate the FCFE.

Computing FCFF and FCFE from EBIT or EBITDA

EBIT and EBITDA can be starting points when calculating FCFF and FCFE. Assuming a firm’s only non-cash expense is depreciation, FCFF can be calculated from net income as:

$$\begin{align*}\text{FCFF}&=\text{Net Income}+\text{Depreciation}+\text{Interest}(1-\text{Tax Rate})\\&-\text{Fixed Capital Investments}-\text{Working Capital Investments}\end{align*}$$

Net income can be expressed as:

$$\begin{align*}\text{Net income}&=(\text{EBIT}-\text{Interest})(1-\text{Tax Rate})\\&=\text{EBIT}(1-\text{Tax Rate})-\text{Interest}(1-\text{Tax Rate})\end{align*}$$

Substituting the net income equation into the FCFF equation, we can calculate FCFF as:

$$\begin{align*}\text{FCFF}&=\text{EBIT}(1-\text{Tax Rate})+\text{Depreciation}\\&-\text{Fixed Capital Investments}-\text{Working Capital Investments}\end{align*}$$

FCFF can be calculated from net income as:

$$\begin{align*}\text{FCFF}&=\text{Net Income}+\text{Depreciation}+\text{Interest}(1-\text{Tax Rate})\\&-\text{Fixed Capital Investments}-\text{Working Capital Investments}\end{align*}$$

Net income can be calculated from EBITDA as:

$$\begin{align*}\text{Net Income}&=(\text{EBITDA}-\text{Depreciation}-\text{Interest})(1-\text{Tax Rate})\\&=\text{EBITDA}(1-\text{Tax Rate})-\text{Depreciation}(1-\text{Tax Rate})\\&-\text{Interest}(1-\text{Tax Rate})\end{align*}$$

Substituting the net income formula into the FCFF equation, we can calculate FCFF as:

$$\begin{align*}\text{FCFF}&=\text{EBITDA}(1-\text{Tax})+\text{Depreciation}(\text{Tax})\\&-\text{Fixed Capital Investments}-\text{Working Capital Investments}\end{align*}$$

Many adjustments for non-cash charges that are required to calculate FCFF when starting from net income are not required when starting from EBIT or EBITDA. This is because many non-cash charges are made after computing EBIT or EBITDA, so they do not need to be added back when calculating FCFF based on EBIT or EBITDA.

FCFE can also be calculated from EBIT or EBITDA. To obtain FCFE based on EBIT or EBITDA, use the expression for FCFF from EBIT or the expression for FCFF from EBITDA, respectively, and subtract after-tax interest and add net borrowing. FCFE is calculated from FCFF as

$$\text{FCFE}=\text{FCFF}-\text{Interest}(1-\text{Tax Rate})+\text{Net Borrowing}$$

FCFE can be calculated from EBIT as:

$$\begin{align*}\text{FCFE}&=\text{EBIT}(1-\text{Tax Rate})-\text{Interest}(1-\text{Tax Rate})+\text{Depreciation}\\&-\text{Fixed Capital Investment}-\text{Working Capital Investments}\\&+\text{Net Borrowing}\end{align*}$$

FCFE can be calculated from EBITDA as:

$$\begin{align*}\text{FCFF}&=\text{EBITDA}(1-\text{Tax rate})-\text{Interest}(1-\text{Tax Rate})\\&+\text{Depreciation}(\text{Tax Rate})-\text{Fixed Capital Investments}\\&-\text{Working Capital Investments}+\text{Net Borrowing}\end{align*}$$

Question

Which of the following is least likely reflected in the calculation of FCFF when beginning with cash flow from operations (CFO)?

1. Interest.
2. Depreciation.
3. Fixed capital investments.

 Solution

The correct answer is B. 

Depreciation is not considered in the calculation of FCFF when beginning with CFO. It is already added back when computing CFO.

C is incorrect. Fixed capital investments are deducted from CFO when calculating FCFF.

A is incorrect. After-tax interest expense is added to CFO when calculating FCFF.

Reading 24: Free Cash Flow Valuation

LOS 24 (c) Explain the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE.