Explain free cash flow to firm (FCFF)

Banking & FinanceFinance ManagementGrowth & Empowerment

<p>Free cash flow to firm (FCFF) represents the available cash flow for both debt and equity holders of the firm. The cash is remaining cash after paying all its expenses including both operating and capital expenditures (taxes, interest, expenditures etc.).</p><p>FCFF is calculated by intrinsic valuation method and terminal value of business.</p><h2>Formulae</h2><p>The formulae to calculate the FCFF are as follows &minus;</p><ul class="list"><li><strong>&nbsp;Free cash flow of firm (Net profit)</strong></li></ul><p style="text-align:center;">Net profit (operating) + expenses (Depreciation and amortization) &ndash; capital expenditure &ndash; changes in net working capital.</p><ul class="list"><li><strong>&nbsp;Free cash flow of firm (Operations)</strong></li></ul><p style="text-align:center;">Cash flow (operations) + Interest expenses* (1-T) &ndash; capital expenditures</p><ul class="list"><li><strong>&nbsp;Free cash flow of firm (Net income)</strong></li></ul><p style="text-align:center;">Net income + charges (non-cash) + interest expenses (1-T) &ndash; Investments in WC &ndash; capital expenditure</p><ul class="list"><li><strong>&nbsp;Free cash flow of firms (EBIT)</strong></li></ul><p style="text-align:center;">EBIT*(1-T) + D&amp;A &ndash; Investments (LT) &ndash; investments in WC</p><ul class="list"><li><strong>&nbsp;Free cash flow of firm (EBIT)</strong></li></ul><p style="text-align:center;">EBITA*(1-T) + D&amp;A * T &ndash; Investments (LT) &ndash; Investments in WC</p><p>Here, T = Tax rate, WC = working capital, LT = Long term, D&amp;A = Depreciation and amortization, EBIT = Earnings before interest and taxes and EBITDA = Earnings before interest, tax and amortization</p><h2>Example</h2><p>Let us consider the following information for understanding purpose&minus;</p><table class="table table-bordered"><thead><tr><th>Sr.No</th><th><br></th><th style="text-align: center;">Amount in $</th></tr></thead><tbody><tr><td style="text-align: center;">1<br></td><td>Sales (a)<br></td><td style="text-align: center;">120<br></td></tr><tr><td style="text-align: center;">2<br></td><td>Operating cost (b)<br></td><td style="text-align: center;">20<br></td></tr><tr><td style="text-align: center;">3<br></td><td>Earnings Before Interest Tax Depreciation and Amortization (a-b = EB)<br></td><td style="text-align: center;">100<br></td></tr><tr><td style="text-align: center;">4<br></td><td>Depreciation (c)<br></td><td style="text-align: center;">10<br></td></tr><tr><td style="text-align: center;">5<br></td><td>Earnings Before Interest and Tax (EB-c = F)<br></td><td style="text-align: center;">90<br></td></tr><tr><td style="text-align: center;">6<br></td><td>Interest (I)<br></td><td style="text-align: center;">15<br></td></tr><tr><td style="text-align: center;">7<br></td><td>Earnings Before Tax (F-I = G)<br></td><td style="text-align: center;">75<br></td></tr><tr><td style="text-align: center;">8<br></td><td>Tax (T)<br></td><td style="text-align: center;">10<br></td></tr><tr><td style="text-align: center;">9<br></td><td>Earnings after Tax (G-T)<br></td><td style="text-align: center;">65<br></td></tr><tr><td style="text-align: center;">10<br></td><td>Working capital investment<br></td><td style="text-align: center;">(15)<br></td></tr><tr><td style="text-align: center;">11<br></td><td>Fixed capital investment (CAPEX)<br></td><td style="text-align: center;">20<br></td></tr><tr><td style="text-align: center;">12<br></td><td>Tax rate<br></td><td style="text-align: center;">35%<br></td></tr></tbody></table><h2>Solution</h2><p>The solution is as follows&minus;</p><p>Interest expense (1-tax rate) = 15 &ndash; (1-35%) &rArr; 9.75.</p><ul class="list"><li>Free cash flow of firm = Net income + charges (non-cash) + interest expenses (1-T) &ndash; Investments in WC &ndash; capital expenditure</li></ul><p style="text-align:center;">65 + 10 + 9.75 &ndash; 15 &ndash; 20 = 49.75</p><ul class="list"><li>Free cash flow of firms = EBIT*(1-T) + D&amp;A &ndash; Investments (LT) &ndash; investments in WC</li></ul><p style="text-align:center;">90*(1-35%) + 10 &ndash; 15-20 &rArr; 33.50</p>
raja
Updated on 06-Jul-2021 12:03:13

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