Variations of Formulae
Figure 19.2: Calculating FCFF and FCFE Using the Statement of Cash Flows
Unfortunately, you have to memorize a number of free cash flow formulas to be fully prepared for the exam. However, we can use the statement of cash flows (as it is required to be reported under U.S. GAAP) as a framework to provide some intuition concerning the free cash flow formulas and perhaps make it a little easier to remember these formulas.
Given our conceptual discussion of FCFF and FCFE, it would make sense to define them as shown in the first column of Figure 19.2.
Free cash flow to the firm is the operating cash flow left after the firm makes working capital and fixed capital investment. Therefore, we can get close to the actual calculation by using the first column in Figure 19.2:
We’re not quite there, however, because of one unique feature of the statement of cash flows: interest expense is considered an operating cash flow, whereas we’d like to call it a financing cash flow. Because interest is tax deductible, the after tax interest expense [interest × (1 − tax rate)] reduces net income; but we want to add it back to net income and then subtract it out as a financing cash outflow. By doing that, we go from our (almost) definition to the actual formula for FCFF (as shown in the second column in Figure 19.2):
We can also use the second column format to calculate FCFE directly from FCFF:
Notice that any financial decisions that affect cash flows below FCFE (e.g., dividends, share repurchases, and share issues) do not affect FCFF or FCFE.
Calculating FCFF from EBIT. FCFF can also be calculated from earnings before interest and taxes (EBIT):
If we start with earnings before interest and taxes (EBIT), we have to add back depreciation because it was subtracted out to get to EBIT. However, because EBIT is before interest and taxes, we don’t have to take out interest (remember that it’s a financing cash flow). We do have to adjust for taxes, though, by computing after tax EBIT, which is EBIT multiplied by one minus the tax rate.
We also make the same adjustments as we did before by subtracting out fixed capital and working capital investment.
Calculating FCFF from EBITDA. We can also start with earnings before interest, taxes, depreciation, and amortization (EBITDA) to arrive at FCFF:
Remember that EBITDA is before depreciation, so we only have to add back the depreciation tax shield, which is depreciation multiplied by the tax rate. Even though depreciation is a noncash expense, the firm reduces its tax bill by expensing it, so the free cash flow available is increased by the taxes saved.
Calculating FCFF from CFO. Finally, FCFF can also be estimated by starting with cash flow from operations (CFO) from the statement of cash flows:
Cash flow from operations is equal to net income plus noncash charges less working capital investment. We have to add back to CFO the after tax interest expense to get to FCFF because interest expense (and the resulting tax shield) was reflected on the income statement to arrive at net income. We also have to subtract out fixed capital investment since CFO only includes changes in working capital investment.
Calculating FCFE from FCFF. Calculating FCFE is easy once we have FCFF:
If we start with FCFF, we have to adjust for the two cash flows to bondholders to calculate FCFE: the after tax interest expense and any new long or short term borrowings. We only subtract the after tax interest expense because paying interest reduces the firm’s tax bill and reduces the cash available to the shareholders by the interest paid minus the taxes saved.
Calculating FCFE from net income. We can also calculate FCFE from net income by making some of the usual adjustments. The two differences between this “FCFE from net income” formula and the “FCFF from net income formula” are (1) after tax interest expense is not added back and (2) net borrowing is added back.
Calculating FCFE from CFO. Finally, we can calculate FCFE from CFO by subtracting out fixed capital investment (which reduces cash available to shareholders) and adding back net borrowing (which increases the cash available to shareholders).
Free Cash Flow With Preferred Stock
The FCFF and FCFE formulas assume that the company uses only debt and common equity to raise funds. The use of preferred stock requires the analyst to revise the FCFF and FCFE formulas to reflect the payment of preferred dividends and any issuance or repurchase of such shares. Remember to treat preferred stock just like debt, except preferred dividends are not tax deductible.
Specifically, any preferred dividends should be added back to the FCFF, just as after tax interest charges are in the net income approach to generating FCFF. This approach assumes that net income is net income to common shareholders after preferred dividends have been subtracted out. The WACC should also be revised to reflect the percent of total capital raised by preferred stock and the cost of that capital source.
The only adjustment to FCFE would be to modify net borrowing to reflect new debt borrowing and net issuances by the amount of the preferred stock. Keep in mind that relatively few firms issue preferred stock.