Question

In: Finance

The term “free cash flow” is frequently applied to cash flows that differ from the definition...

The term “free cash flow” is frequently applied to cash flows that differ from the definition for FCFF that should be used to value a firm. Two such definitions of free cash flow are given below. Compare these two definitions for free cash flow with the technically correct definition of FCFF used in the reading.

A. FCF = Net income + Depreciation and amortization − Cash dividends − Capital expenditures

B. FCF = Cash flow from operations (from the statement of cash flows) − Capital expenditures (130 words minimum)

Solutions

Expert Solution

FCFF is the free cash flow to the firm and represents the cash that is available to pay to the investors of a company. This cash is available after paying cost of doing business (i.e. operating costs), after investing in assets (both short term and long term). Here it should be noted that this cash is available to both bondholders and stockholders as both are investors in a company.

Thus we can say that FCFF = cash flow from operations + interest expense * (1-tax rate) – capital expenditures

The first definition of FCF i.e. FCF = Net income + Depreciation and amortization − Cash dividends − Capital expenditures is not FCFF because of the fact that cash dividends has been deducted in the equation. Cash dividend is payment made to stockholders and hence this should not have been deducted.

The second definition of FCF i.e. FCF = Cash flow from operations (from the statement of cash flows) − Capital expenditures is not FCFF as well because interest expense is not added back here. It should be noted that cash flow from operations = net income + non cash expenses – increase in working capital. Net income computation deducts interest expenses and hence it should be added back.

(206 words)


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