Calculating FCF

Question 1

Let’s talk more about how you calculate Free Cash Flow. Is it always correct to leave out most of the Cash Flow from Investing section and all of the Cash Flow from Financing section?

Answer 1

Mostly yes, as items other than CapEx are generally non-recurring.
- if you have advance knowledge a company is going to sell or buy a certain amount of securities, issue a certain amount of stock, or repurchase a certain number of shares every year, then factor those in.

Question 2

Why do you add back non-cash charges when calculating Free Cash Flow?

Answer 2

Same reason you add them back on the CFS, want to reflect the fact they save the company taxes, but company does not actually pay expense in cash

Question 3

What’s an alternate method for calculating Unlevered Free Cash Flow (Free Cash Flow to Firm)?

Answer 3

here are a few common ones:
• EBIT * (1 – Tax Rate) + Non-Cash Charges – Changes in Operating Assets and Liabilities – CapEx
• Cash Flow from Operations + Tax-Adjusted Net Interest Expense - CapEx
• Net Income + Tax-Adjusted Net Interest Expense + Non-Cash Charges – Changes in Operating Assets and Liabilities – CapEx
The difference with these is that the tax numbers will be slightly different as a result of when you exclude the interest.

Question 4

What about alternate ways to calculate Levered Free Cash Flow?

Answer 4

• Net Income + Non-Cash Charges – Changes in Operating Assets and Liabilities – CapEx – Mandatory Debt Repayments
• (EBIT – Net Interest Expense) * (1 – Tax Rate) + Non-Cash Charges – Changes in Operating Assets and Liabilities – CapEx – Mandatory Debt Repayments
• Cash Flow from Operations – CapEx – Mandatory Debt Repayments

Question 5

As an approximation, do you think it’s OK to use EBITDA – Changes in Operating Assets and Liabilities – CapEx to approximate Unlevered Free Cash Flow?

Answer 5

Inaccurate as it excludes taxes completely, minus taxes as well, shouldn’t be overlooked.

Question 6

What’s the point of that “Changes in Operating Assets and Liabilities” section? What does it mean?

Answer 6

If assets increase by more than liabilities, reduction in cash flow

Question 7

What happens in the DCF if Free Cash Flow is negative? What if EBIT is negative?

Answer 7

Can still run analysis as normal

Question 8

Let’s say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow in your DCF – what changes?

Answer 8

Levered gives you EV, since cash flow is only available to equity investors, as debt investors have already been paid with interest payments and principal repayments

Question 9

If you use Levered Free Cash Flow, what should you use as the Discount Rate

Answer 9

You would use Cost of Equity rather than WACC since we’re ignoring Debt and Preferred Stock and only care about the Equity Value for Levered FCF.

Question 10

Let’s say that you use Unlevered Free Cash Flow in a DCF to calculate Enterprise Value. Then, you work backwards and use the company’s Cash, Debt, and so on to calculate its implied Equity Value.
Then you run the analysis using Levered Free Cash Flow instead and calculate Equity Value at the end. Will the implied Equity Value from both these analyses by the same?

Answer 10

No, as in practice its impossible to pick equivalent assumptions, so the two methods will rarely produce the same value.