Question

When calculating the free cash flow of a company base on its year end earning, what kind of assumptions will you use, explain why are you using those assumptions. (2 paragraphs)

Answer 1

Operating Cash Flow Projections

The first and most important factor in calculating the FCF value is estimating the series of operating cash flow projections. There are a number of inherent problems with earnings and cash flow forecasting that can generate problems with DCF analysis.

Capital Expenditure Projections

Free cash flow projection involves projecting capital expenditures for each model year. Again, the degree of uncertainty increases with each additional year in the model. Capital expenditures can be largely discretionary; in a down year, a company's management may rein in capital-expenditure plans (the inverse may also be true)

Discount Rate and Growth Rate

Perhaps the most contentious assumptions in a FCF model are the discount rate and growth rate assumptions. There are many ways to approach the discount rate in an equity FCF model. Both approaches are quite theoretical and may not work well in real-world investing applications. Other investors may choose to use an arbitrary standard hurdle rate to evaluate all equity investments. In this way, all investments are evaluated against each other on the same footing. When choosing a method to estimate the discount rate, there are typically no surefire (or easy) answers

The other assumptions which need to use while calculation FCF or a forecast cash flow, we need to understand how a business operates. How does a business create value.

1.   Sales growth rates
2.   EBITDA margins
3.   Cash tax rates
4.   Fixed capital investment or capital expenditure
5.   Working capital requirements.