Forecasting Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE)

Forecasting FCFF and FCFE

There are two approaches used to forecast FCFF and FCFE:

1. Applying a constant growth rate to the current free cash flow: This assumes the historical growth rate will apply to the future. This would be appropriate if the historical free cash flow has been growing at a constant rate, which is expected to continue in the future.
2. Forecasting some components of free cash flow: These components are EBIT(1−Tax), net non-cash charges, fixed capital investments, working capital investments. This is a more complicated approach.

EBIT can be forecasted by forecasting sales and a firm’s EBIT margin based on historical data and the current and expected economic environment.

Capital needs (fixed capital investments and working capital investments) can be forecast based on the historical relationship between increases in sales and investments in fixed and working capital, both of which bear a relationship with a firm’s sales.

Sales-Based Forecasting Method

A central assumption of the sales-based forecasting method is:

1. Investments in fixed capital above depreciation (Fixed capital investments – Depreciation) and investments in working capital both bear a constant relationship to forecast increases in sales.
2. The debt ratio is also assumed to remain constant. The debt ratio would then be the percentage of net new investments in fixed capital and working capital financed by debt.
3. If depreciation reflects the annual cost for maintaining the existing capital, the incremental fixed capital investments should be related to the capital expenditures required for growth. The following inputs would be required:
   • Forecasts sales growth rates.
   • Forecasts of the after-tax operating margin or profit margin.
   • An estimate of the relationship of incremental fixed capital investments and increase in sales.
   • An estimate of the relationship between working capital investments and an increase in sales.
   • An estimate of debt ratio.

FCFF is forecasted as EBIT (1−Tax rate) less incremental fixed capital investments and incremental working capital investments. Incremental fixed capital investments and incremental working capital investments are estimated by multiplying their past proportion to sales increases by the projected sales increases.

• Incremental fixed capital investments as a proportion of sales increases are computed as:
  $$\frac{\text{Capital Expenditures}-\text{Depreciation Expense}}{\text{Increase in Sales}}$$
• Incremental fixed working capital investments as a proportion of sales increases are computed as:
  $$\frac{\text{Increase in Working Capital Investments}}{\text{Increase in Sales}}$$

From this approach, capital investments have two components:

1. Investments are necessary to maintain existing capacity (fixed capital replacements). Here, investments to maintain capacity are likely to be related to the current level of sales.
2. Investments are necessary for growth. Investments for growth are likely to be related to the forecast of sales growth.

Assuming depreciation is the only non-cash charge, FCFF can be forecasted as:

$$\begin{align*}\text{FCFE}&=\text{Net Income}-(\text{Fixed Capital Investments}-\text{Depreciation})\\&-\text{Working Capital Investments}+\text{Net Borrowing}\end{align*}$$

(Fixed capital investments – Depreciation) represents the incremental fixed capital investments less the depreciation amount. The forecasted net borrowing can be eliminated by using an assumed debt ratio (DR).

$$\begin{align*}\text{Net Borrowing}&=\text{DR}(\text{Fixed Capital Investments}-\text{Depreciation})\\&+\text{DR}(\text{Working Capital Investments})\end{align*}$$

Incorporating this into the equation, FCFE can be calculated as:

$$\begin{align*}\text{FCFE}&=\text{Net income}-(1-\text{DR})(\text{Fixed Capital Investments}-\text{Depreciation})\\&-(1-\text{DR})\text{Working Capital Investments}\end{align*}$$

From this equation, FCFE equals net income less the amount of incremental fixed capital investments and working capital financed by equity.

Example: Forecasting FCFF

Consider the following information:

$$\small{\begin{array}{l|r}\text{Sales} & $2,320\\ \hline\text{Sales growth} & $116 \\ \hline\text{EBIT} & $348 \\ \hline\text{Tax rate} & 25\% \\ \hline\text{Purchase of fixed assets} & $464 \\ \hline\text{Depreciation expense} & $406 \\ \hline\text{Change in working capital} & $29 \\ \hline\text{Net income margin} & 8\% \\ \hline\text{Debt ratio} & 25\%\\ \end{array}}$$

FCFF is closest to:

Solution

$$\begin{align*}\text{Sales growth}&=\frac{\$116}{\$2320}=5\%\\ \\ \text{EBIT margin}&=\frac{\$348}{\$2320}=15\%\\ \\ \text{Incremental FC/Sales growth}& =\frac{(\$464-\$406)}{\$116} = 50\%\\ \\ \text{Incremental WC/Sales growth}&=\frac{\$29}{\$116} = 25\%\\ \\ \text{Sales}&=\$116 + \$2320=\$2436\\ \\ \text{EBIT}&= \$2436 × 15\% =\$365\\ \\ \text{EBIT}(1-\text{Tax rate})&=\$365 × (1- 25\%)=\$274\\ \\ \text{Incremental FC}&=\$116\times50\% =\$58\\ \\ \text{Incremental WC}&=\$116\times25\% =\$29\\ \\ \text{FCFF}&= \text{EBIT} (1-\text{Tax rate})\\&-∆\text{Capital expenditures}-∆\text{WCInv} \\&=365(1-25\%)-\$58-\$29 =\$187\end{align*}$$

Question

Which of the following is least likely a required input when forecasting FCFF?

1. Tax rate.
2. Forecasted sales growth rate.
3. Forecasted after-tax operating margin or profit margin.

Solution

The correct answer is A. 

The tax rate is not an input required when forecasting the FCFF, especially when an analyst already has the after-tax operating margin or profit margin.

B is incorrect. A forecast sales growth rate is required when forecasting FCFF by forecasting its components.

C is incorrect. A forecast of after-tax operating margin or profit margin is required when forecasting FCFF by forecasting its components.

Reading 24: Free Cash Flow Valuation

LOS 24 (e) Describe approaches for forecasting FCFF and FCFE.