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6. Free cash flow Accounting statements represent a company’s earnings, but this is not the real cash that a company generates. Earnings data can be manipulated and can be deceiving. Thus, corporate decision makers and security analysts focus on the free cash flow that a firm generates to analyze the company’s real cash position. Which of the following statements best describes free cash flow? Cash flows generated by operating the business Residual cash flow after taking into account operating cash flows, including fixed-asset acquisitions, asset sales, and working-capital expenditures Suppose you are the only owner of a chain of coffee shops near universities. Your current cafés are doing well, but you are interested in starting a fine-dining restaurant. You decide to use the cash generated from your existing business to enter into a new business. Your accountant provides you with the following data on your current financial performance: Financial update as of June 15 • Your existing business generates $111,000 in EBIT. • The corporate tax rate applicable to your business is 25%. • The depreciation expense reported in the financial statements is $21,143. • You don’t need to spend any money for new equipment in your existing cafés; however, you do need $16,650 of additional cash. • You also need to purchase $8,880 in additional supplies—such as tableclothes and napkins, and more formal tableware—on credit. • It is also estimated that your accruals, including taxes and wages payable, will increase by $5,550. Based on your evaluation you have   in free cash flow. Free cash flow can be used for various reasons, including distributing it to stockholders and debtholders. Which of the following is not a use of free cash flow? Acquiring operating assets Distributing dividends to stockholders

Answer 1

The statement that describes what Free Cash Flow is (FCF) is:

Residual cash flow after taking into account operating cash flows, including fixed-asset acquisitions, asset sales, and working-capital expenditures

FCF is the balance amount available to both debt & equity holders.

It's formuls is

FCF=EBIT*(1-Tax rate)+depn. & Amortisations+/- Net change in Fixed Assets+/- Changes to Net Working capital

For the given case,

FCF =(111000*(1-25%))+21143-16650-(8880-5550)

84413

So,

Based on the above evaluation we have $ 84413   in free cash flow.

Acquiring operating assets

is NOT a use of FCF

as FCF is that cash available to the business cash after meeting operating expenses & asset purchases .

This cash is used for repayment of debts, distribution of cash dividends to stockholders, business expansion or stock re-purchase---ie. Meant for all financing activities only.