Question

A company has EBIT of $30 million, depreciation of $5 million, and a 40% tax rate. It needs to spend $15 million on new fixed assets and $5 million to increase its current assets. It expects its accounts payable to decrease by $2 million, its accruals to increase by $3 million, and its notes payable to increase by $8 million. The firm’s current liabilities consist of only accounts payable, accruals, and notes payable. What is its free cash flow?

Answer 1

To find the free cash flow we need to first calculate the change in net operating working capital.
Change in net operating working capital=Change in current assets-(Change in current liabilities - Change in notes payable)
Given that the company needs to spend $5 million to increase its current assets, so change in current assets=$5 million

Change in current liabilities:
The company expects its accounts payable to decrease by $2 million, so it will be denoted as -$2 million (as it is a cash outflow)
The company expects its accruals to increase by $3 million, so it will be denoted as +$3 million
The company expects its notes payable to increase by $8 million, so it will be denoted as +$8 million
Now, total change in current liabilities (in million) =Change in accounts payable+Change in accruals+Change in notes payable=-$2+$3+$8=$9

Now, change in notes payable = +$8 million

Change in net operating working capital=Change in current assets-(Change in current liabilities - Change in notes payable)
=$5-($9-$8)=$5-$1=$4

So, change in net operating working capital=$4 million

Free cash flow (FCF)=[(EBIT*(1-Tax)+depreciation and amortization] - [Capital expenditures + Change in net operating working capital]

Given that EBIT=$30 million
Depreciation=$5 million
Tax rate=40%
Capital expenditure (expense on new fixed assets)=$15 million

FCF=[$30(1-40%)+$5]-[$15+$4]
=[$30(1-.4)+$5] - [$19]
=[$30*.6+$5] - $19
=[$18+$5]-$19
=$23-$19=$4

Therefore, free cash flow is $4 million