Question

Reasons for a company to want to have some free cash flow available to it at all times?

Why would the government tax system at the federal and states level be set up so that the tax rate on regular income (wages and profits) is higher than the tax rate on interest, dividends, and capital gains?  Who benefits from this?   

What is the concept of book value and how it is calculated.  Why is it different from stockmarket value?  Which is better, higher book or higher market, and why?  

Answer 1

1. Free cash flow to firm is nothing but the Cash flow from operations- Capex for that particular period. Now, if this is positive it can be used to provide returns to shareholder in the form of dividends/ share buybacks etc. Or if company feels there are any growth / acquisition prospects company can also invest the cash into that. Thus in the nutshell if company has free cash flow it can at all times be used in taking actions that would enhance shareholder value.

2. Book value is nothing but the value of assets - liabilities.

Now let's assume there is a very small company with only one machine. Value of machine is 100. Company has taken a loan of 80 to fund it( liabilities). And the remaining 20 is put in from shareholder funds. This is 20.

Now, from that machine, I generate a very good cloth which makes me a profit of 100/yr.

This means that, my machine is now much more valued since it's generating me a very handsome return. So, market will value my machine/ my company at much more value than what is my book value of asset.

So, this creates a difference. To summarise, market values company based on its free cash flows and book value which is booked on balance sheet is based on purchase/built value of assets/ liabilities.

So for me as a company, obiviously higher market value is beneficial as market is valuing my equity much more than what I had invested.

3. Ragarding your question on tax rates, I don't think this is true in all jurisdictions. Some jurisdictions have it different and this is baed on what fiscal policies government is planning to put in place and what would be the budgetary situation at that point of time.