Free Cash Flow
Corporate Finance: MBAC 6060
Professor Jaime Zender
SCF Basics
SCF is a summary of a company’s transactions for a
given period that effect the cash account.
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It provides information about the firm’s ability to generate
cash and the effectiveness of its cash management. Where
is cash coming from and where is it going to?
SCF is derived from the income statement for the period
and (at least) the two balance sheets surrounding the period.
Cash is the “life blood” of the firm so the SCF can be an
important diagnostic tool and provide insight into which
financial ratios should be calculated to assess the strengths
and weaknesses of the firm.
Cash flow information is commonly viewed as a (the)
crucial piece of information for assessing the firm and its
financial health by outside audiences.
SCF
The generic structure of the SCF is:
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Cash provided (used) by operating activities.
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Cash provided (used) by investing activities.
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Basic running of the business, how fast cash comes in versus how fast
it goes out. Tells us about how past investments are generating cash.
Acquisition/sale of new assets.
Cash provided (used) by financing activities.
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Raising new capital/retiring old, significant sources/uses of cash.
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Foreign exchange adjustments (we will largely ignore)
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Increase (decrease) in cash.
Cash – beginning of the period.
Cash – end of the period.
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SCF
Operating Activities:
Start with:
 Add:
 Subtract:
 Add:
 Total to find:
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Net Income (from Operations)
Depreciation & Amortization
Change in non-cash oper. NWC
Change in Deferred Income Tax*
Cash flow from Operations
SCF
Investing Activities:
Acquisitions of fixed assets are (generally) cash
outflows.
 Sales of fixed assets (net of any tax implications)
are (generally) cash inflows.
 Acquisitions of (LT) financial assets are outflows.
 Sales/Maturities of financial assets are inflows.
 The net is Cash flow from Investing Activities.
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SCF
Financing Activities:
Add the amounts of newly issued long-term or
short-term debt.
 Subtract the amount of long-term or short-term
debt retired.
 Subtract the amount of stock repurchases.
 Add the amount of new stock issues.
 Subtract total amount of dividends paid.
 Total is cash flow from financing activities.
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Free Cash Flow
While the SCF is a good diagnostic tool, it does not present
information in a form useful for valuation purposes.
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Valuation does not focus on the change in the cash account as is done on
the SCF. Cash on hand is really just another asset.
Recall our basic valuation equation. We need forecasts of all future
cash flow expected to be generated from currently owning a firm or
an asset more generally. So we introduce Free Cash Flow (FCF).
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The cash flow that would be generated by a firm and be available to be
dispersed to its existing claimants if the firm were all equity financed.
The cash flow of a company measured after it has collected its revenues,
paid it expenses, and makes all investments (LT & ST) necessary to
implement it’s business strategy – if it were entirely equity financed.
It is important to note that free cash flow is an enterprise level
concept. In practice, we use it (in combination with an appropriate
discount rate) to value a firm or asset.
FCF
The most theoretically correct cash flow figure to use
in DCF valuation is (some variant of) Free Cash Flow.
FCF:
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Start with:
Add back:
Subtract:
Subtract:
Add:
Subtract:
Add:
Net Income (from Operations)
Depreciation & Amortization
Change in non-cash oper. NWC
Change in required cash
Change in deferred income tax
Net Capital Expenditures
After tax interest = (1-Tc)Interest Exp.
Note: this is really free cash flow from operations, we are ignoring any non-operating
cash flows not contained in Net Cap Ex.
Net Income
Net income is a reasonable place to start. It
measures, in an accounting sense, what the
existing assets are generating.
Net income, however, is not a measure of any kind
of cash flow (it is specifically designed not to be),
so clearly we need to make adjustments.
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Accrual accounting.
Off income statement expenditures.
Interest.
Accrual Accounting
The most obvious problem with using net
income to capture cash flow is that non-cash
expenses have been deducted and non-cash
revenue has been included.
The largest (commonly) is depreciation (in the
past, amortization of goodwill).
In order to help turn net income into free cash
flow we have to add (subtract) such expenses
(revenues) back into (from) net income.
Accrual Accounting
Revenue is booked when sales are made. This is
true regardless of whether the sale is for cash or
credit (i.e. whether the cash came in or not).
To find cash flow we want to reflect any (and
only) sales that actually generated cash (obvious).
We could count only cash sales but what would
that miss?
It’s the timing of credit sales that are the problem.
We correct by subtracting (why subtract?) the
change in accounts receivable.
Accrual Accounting
Expenses work similarly.
Expenses are booked even if we only record an
accounts payable rather than an actual cash
outflow.
We correct by adding the change in accounts
payable.
The shortcut we use to deal with lots of these
corrections at once is to subtract the change in
non-cash operating NWC**. Why do we subtract
this change?
Tax Accruals
Commonly, there are three tax accrual accounts that tell us
the difference between “allowance for income taxes”
(public books) and actual cash taxes paid (tax books).
Prepaid taxes is a short term asset account, taxes payable is
a short term liability, and deferred taxes is a long term
liability (occasionally you see a 4th, deferred tax assets).
We can change “book” taxes to “cash” taxes by adding the
change in the asset account(s) and subtracting the changes
in the liability accounts to “allowance for income taxes.”
However, commonly taxes paid is not the goal, rather it is
free cash flow. The two short term accounts are dealt with
via the change in NWC so we only have to add the change
in deferred taxes to net income to finish with tax accruals.
Conceptually these are non-current assets and liabilities but
I break them out to highlight their importance.
Off Income Statement Flows
An expense we want to take out of free cash flow that isn’t
reflected on the income statement is net capital expenditures.
We added back the reflection of past expenditures that
appears on the income statement (depreciation) but we want
to make sure that all valuable investments are made so that
free cash flow is what is left after accounting for investments
necessary for the efficient operation of the firm.
We could find this value for last period from the statement of
cash flow in the investment cash flow section once we ignore
the financial asset transactions.
Future values can be estimated by the change in gross fixed
assets over the period (or the change in net fixed assets plus
the period’s depreciation expense).
Interest
A final thing that was taken out of net income that
should be included in free cash flow is interest
payments.
We don’t want it removed from free cash flow
because interest is a cash flow that has been
generated and (commonly: cash versus non-cash
interest) was actually paid to contributors of
capital by the firm. Clearly this should be part of
what we call free cash flow for the period.
Thus add (cash) interest back into net income.
Taxes For The All Equity Firm
The “what if” part of the definition.
The big difference between the taxes paid by an all
equity financed firm and a firm that also uses debt
financing is that a firm using debt pays interest.
The payment of interest expense generates a tax
deduction.
For each dollar of interest paid the firm saves $1×tc,
where tc is the firm’s marginal corporate tax rate.
Thus the total tax savings that an all equity firm would
not have received (that the firm using debt did
receive) is $Interest×tc.
We thus want to subtract this from net income to find
free cash flow.
After Tax Interest
A shortcut commonly used in calculating free cash
flow is that we add “after tax” interest.
This takes care of “putting interest back” into net
income and “adjusting taxes” for the “what if” part
of the exercise all at once.
In other words, adding back interest and
subtracting the interest tax shield (as long as
interest expense and cash interest are equal,
sequentially from net income effectively adds after
tax interest to net income:
+$Interest – tc×$Interest = +(1-tc)$Interest
FCF
Alternatively, FCF can be estimated as:
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EBIT less TcEBIT = EBIT(1-Tc) = unlevered NI
Add Depreciation & Amortization
Subtract Change in non-cash operating NWC
Subtract Change in required Cash
Add the change in Deferred Income Taxes
Subtract Net Capital Expenditures
What crap! You haven’t started from the same
figure, you haven’t added back interest, how can
this be the same?
Be sure you fully understand why. Think of
alternative ways of finding FCF, it is instructive.
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For example, how would you find FCF from the SCF?
FCF from SCF
Start with Cash Flow from Operations
Add back (cash) interest
Subtract the interest tax shield (interest expense)
Giving unlevered Cash Flow from Operations
Subtract the change in required cash (investment)
Subtract Net Capital Expenditures (investment)
Giving (unlevered) Free Cash Flow
Free Cash Flow to Equity
It may be the case that your purpose is to find the
value of a firm’s equity rather than the value of the
firm itself.
One way to accomplish this is to identify the free
cash flow that “belongs” to the equityholders
(FCFE) and value the equity directly from that
measure of cash flow (in combination with an
appropriate discount rate).
To do this we start with free cash flow and “strip
out” the cash flows that will go to or come from
other claimants.
Free Cash Flow to Equity
Start with Free Cash Flow
Subtract (cash) interest paid
Add the interest tax shield
Giving levered Free Cash Flow or CCF
Subtract preferred stock dividends (if any)
Add the change in debt financing
Add the change in preferred stock financing
Giving FCFE
Reconciling with SCF
Accountants being who and what they are:
If we start with FCFE
 Subtract common stock dividends
 Add the change in equity financing
 This equals the change in excess cash
 Add the change in required cash
 This equals the change in the cash balance
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FCF Challenge Question-34% tax
Income Statement (in $ Millions)
Sales
COGS
Gross Profit
SG&A Expenses
Research and Development
Depreciation
Operating Income
Other Income
Earnings before interest and taxes
Interest income (expense)
Pretax Income
Taxes
Net Income
2012 Actual
$ 175.00
$ (70.00)
$ 105.00
$ (38.50)
$
(3.50)
$
(8.00)
$ 55.00
$
$ 55.00
$
(2.57)
$ 52.44
$ (17.83)
$ 34.61
2013 Est
$ 191.63
$ (76.65)
$ 114.98
$ (42.16)
$ (3.83)
$ (8.00)
$ 60.99
$ $ 60.99
$ (2.57)
$ 58.42
$ (19.86)
$ 38.56
2014 Est
$ 209.83
$ (83.93)
$ 125.90
$ (46.16)
$ (4.20)
$ (9.00)
$ 66.54
$ $ 66.54
$ (2.57)
$ 63.97
$ (21.75)
$ 42.22
FCF Challenge Question
Balance Sheets (in $ Millions)
Assets
Current assets
Cash
Accounts receivable
Inventories
Other current assets
Total current assets
Long-term Assets
Land
Buildings
Equipment
Less accumulated depreciation
Net property, plant, and equipment
Other long-term assets
Total long-term assets
Total Assets
2012 Actual 2013 Est
$
$
$
$
$
$
$
$
$
$
$
$
$
30.73
13.42
8.63
2.50
55.28
20.00
35.00
25.00
(16.00)
64.00
15.00
79.00
134.28
$ 77.13
$ 14.70
$ 9.45
$ 2.50
$ 103.78
$ 20.00
$ 35.00
$ 25.00
$ (24.00)
$ 56.00
$ 15.00
$ 71.00
$ 174.78
2014 Est
$ 117.30
$ 16.10
$ 10.35
$ 2.75
$ 146.49
$ 20.00
$ 35.00
$ 35.00
$ (33.00)
$ 57.00
$ 15.00
$ 72.00
$ 218.49
Liabilities and Stockholder's Equity
Current Liabilities
Accounts Payable
Bank Loan (revolver)
Current portion of long-term debt
Other current liabilities
Total current liabilities
Long-Term Liabilities
Long-term debt
Capital lease obligations
Total long-term debt
Deferred taxes
Other long-term liabilities
Total long-term liabilities
Total Liabilities
Stockholders Equity
Total L and S Equity
2012 Actual 2013 Est
$
$
$
$
$
17.26
3.00
6.00
26.26
$
$
$
$
$
$
$
$
$
45.00
45.00
7.80
52.80
79.06
55.22
134.28
2014 Est
$ 18.90 $ 20.70
$ 3.10 $ 3.20
$ $ $ 6.00 $ 6.00
$ 28.00 $ 29.90
$ 45.00
$ $ 45.00
$ 8.00
$ $ 53.00
$ 81.00
$ 93.78
$ 174.78
$ 45.00
$ $ 45.00
$ 7.60
$ $ 52.60
$ 82.50
$ 135.99
$ 218.49
FCF Challenge Question
Free Cash Flow
Unlevered Net Income (EBITx(1-t))
Add Depreciation
Less Change in non-cash NWC
Less Change in required cash
Add change in deferred tax
Less Net Cap Ex
FCF
2013 Est 2014 Est
$ 40.25
$ 8.00
$ 0.46
$ 1.37
$ 0.20
$ $ 46.62