Question

Indicate the effect on this period's FCFF and FCFE of a change in each of the items listed below.

Assume a $100 increase in each case and a 40 percent tax rate.

Please indicate whether ( Positive, Negetive, No change) for each one.

A) Net Income

B) Cash Operating expenses

C) Depreciation

D) Interest Expense

E) EBIT

F) Accounts Receivable

G) Accounts Payable

H) Property, Plant and equipment

I) Notes Payable

J) Cash dividends paid

K) Proceeds from issuing new common shares.

L) Common stock share repurchases

*Please attach workings for each item as well

Answer 1

Free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) are the cash flows available to, respectively, all of the investors in the company and to common stockholders.

• FCFF and FCFE are frequently calculated by starting with net income:

  FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv

  FCFE = NI + NCC – FCInv – WCInv + Net borrowing

• FCFF and FCFE are related to each other as follows:

  FCFE = FCFF – Int(1 – Tax rate) + Net borrowing

• FCFF and FCFE can be calculated by starting from cash flow from operations:

  FCFF = CFO + Int(1 – Tax rate) – FCInv

  FCFE = CFO – FCInv + Net borrowing

• FCFF can also be calculated from EBIT or EBITDA:

  FCFF = EBIT(1 – Tax rate) + Dep – FCInv – WCInv

  FCFF = EBITDA(1 – Tax rate) + Dep(Tax rate) – FCInv – WCInv

  FCFE can then be found by using FCFE = FCFF – Int(1 – Tax rate) + Net borrowing.

Account Payables :for the increase in payable effect consider the below approach:

Notes payable is a short term interest bearing liability considered as part of debt capital. Increase in notes payable is similar to increase in net borrowing meaning that more cash is available for equity providers.

Assume that a trading company has only cash transaction and no non cash expenses like depreciation or amortization and no loans no opening or closing inventory… Such that the profit earned by the company equals the cashflow during the period… I.e cashflow statement starts at net profit and there will be no adjustment…

In the next year company purchases goods on credit and got a closing accounts payable balance of $ 100 in that year ( i.e. saved $100 temporarily in that year)…

What will happen to the cashflow and profit… Will they still be equal? No! CF ( be it fcff or fcfe) will be more by 100

Net profit assume $10000

Only Adjustemnt : increase in payable 100

Cashflow : 10100

Depreciation itself has no effect in cash flows because it is non-cash. The only effect it has on cash flows is by indirectly affecting taxes to be paid, which are cash out.

If depreciation increases by 100, then the taxable income has decreased by 100. This means you pay less taxes by 40, thus 40 more FCFF.

Note that this reasoning is true as long as you have calculated FCFF using indirect method of cash flow: starting from NI or above and adjusting accounts by non-cash movements and WK variations.