Free Cash Flow Theory Flashcards
Explain method 1 in order to forecast free cash flow
- The equation to caclulate the free cash flow based on Method 1 is:
- (Ct – It) = OIt – (NOAt – NOA t-1)
- It is saying that the free cash flow is the operating income – the change in net operating assets
- In order to calculate this one has to reformulate the GAAP Balance Sheet to identify the net operating assets and also reformulate the GAAP income statement to identify the operating income (After tax).
- However, this requires a potentially complicated reformulation of the financial statements.
Explain the method 2 in order to forecast free cash flow
• Method 2 is actually an approximation to the result given by method 1 by adjusting accounting income by individual line items that, taken together, approximate the change in net operating assets
• The logic underpinning method 2 is that all of the adjustments that are made in order to get from operating income to free cash flow taken toegether give an estimate of the change in net operating asset during the perdiod
• This is why Method 1 and Method 2 should lead to approximately the same free cash flow:
Free cash flow valuation: Calcuaate FCF by method 2:
Operating profit after tax
Plus: depreciation
Less: Additiones (net of disposals) capex
Less: Increase in working capital
Free cash flow
4) Explain why you would expect the free cash flow forecast given my method 1 and method 2 to be equal, Also explain why you might expect some analyst implematination of method 2 to give a free cash flow forecast that differ from that that would be given by method 1.
- Method 1; (Ct – It) = OIt – (NOAt – NOA t-1)
- Operating income after tax minus changes in net operating assets equals free cash flow, where as method 2 is breaking down the details of changes in net operating asset into increase (decrease) in net working capital, net addition, an depreciation (line items).
- Thus this aggregate changes should equal the change in net operating assets income#
- However methid and method 2 of FCF in analyst reports migh be different because:
- 1) Tax estimites that are used in methid 2 might not be the same as methid1 , which uses the effective tax rate in the income statement. Therefore the net operating income after tax of both methods will be different. Consequently the result of FCF of those methods will be different
- 2)In a complicated practical seeting where approximations and simplifications may have to be used method 1 and 2 may give different results
5) The free cash flow measurement method described in the course as method 3 estimates free cash flow by starting with figures reported in a GAAP statement of cash flows and making a number of adjustments to these figures. Explain the adjustments that you would be required to make in implementing method 3, and explain the rational for those aqdjustments. ( This part of the question does not require reference to the numbers used in tpart (a) of the question
• Method 3 is achieving an approximation to the result given by method 1 by using figures from the cash flow statement, where the cash flow statement will give:
a) net cash provided by operating activities
b)net cash (Used in) provided by investing activites
• However, you may not be able to use the sum of these reported cash flow as as estimate of free cash flow because there are two key problems:
1) In the use-GAAP statement, interest received and interest paid are not eliminated from net income in arriving at “net cash provided by operating activities”. The US_GAAp figure needs to be adjusted using information available in notes to financial statements. This can also happen with IFRS. IAS 7 (Paragraph 33) allows interest to be shows either as an operating items or as a financial item.
2) In the US-GAAp statements (and sometimes under IFRS), “net cash used in investing activities” includes both operating investments and financial investments. Financial ivestments are transfers within net financial assets, and are not parts of the free cash flow generated by the operating entiy.
Descib the two method other than used in part (a) that might be used in parcatice to estmate free cash flow from published financial statement to forecast free cash flow from forecasts of puplished fincial sgtatemnts. (During the course, these methods were terms method 2 and method 3). For each of method 2 and method 3, explain why these methods may be used to give approximations to the free cash flow measures that would be given by method 1 (for this part of the question, your are not required to use the numerical data used in the previous questions.). METHOD 2
Method 2)
• FCF can be estimated from forecast I/S and BS by:
1)Use the nubers of operating income after tax (EBIT * (1-tax))
2) subtracting the items lines that lead to a chance in net operating assets:
Free cash flow valuation: Calcuaate FCF by method 2:
Operating profit after tax
Plus: depreciation
Less: Additiones (net of disposals) capex
Less: Increase in working capital
Free cash flow
• Thse aggregrated changes in NPA items equal to changes in total net operating Asset based on method 1. Therefore FCF of method 1 and 2 should equal the same result
Descib the two method other than used in part (a) that might be used in parcatice to estmate free cash flow from published financial statement to forecast free cash flow from forecasts of puplished fincial sgtatemnts. (During the course, these methods were terms method 2 and method 3). For each of method 2 and method 3, explain why these methods may be used to give approximations to the free cash flow measures that would be given by method 1 (for this part of the question, your are not required to use the numerical data used in the previous questions.). METHOD 3
Method 3:
• FCF can be estimated by using the forecasted cash flow statements;
1) However the reported cash flow from operations need to be adjusted by financial items, interest payments after tax and interest income after tax or net interest payment after tax. This elimination would lead to a cash flow that is relecting the depreciation and change in NWC that is covered by the change in NOA of the method 1.
2)Additionally some financing items that are nor relevant to operating activities of the cash flows from investing activities would to be eliminated. This result would reflect the sum of capital expenditures and net additions and disposal, which is a relection of the other part of the changes in NOA that is also covered by method 1.
• The some of the adjusted cash flows from operations and investing activities would to the same free cash flow result of method 1.
) Identify the principal adjustments that you would have to make to “Net cash provided by operating activities” and “net cash used in invsting activities” in order to estimakte free cash flow for the operating entitiy on the basis of the consolidated statement of cash flows prepared under US GAAP ( or in order to forecast free cash flow for the operating entity from a forecast of a US GAAP statement of cash flows).
1) reported cash flow from operations need to be adjusted by financial items, interest payments after tax and interest income after tax or net interest payment after tax. This elimination would lead to a cash flow that is reflecting the depreciation and change in NWC that is covered by the change in NOA of the method 1.
2) Additionally some financing items that are nor relevant to operating activities of the cash flows from investing activities would to be eliminated (For example the purchase or sale of interest bearing securities).This result would reflect the sum of capital expenditures and net additions and disposal, which is a reflection of the other part of the changes in NOA that is also covered by method 1.
Outline the principal criticisms of the free cash flow based methid of valuing businesses.
Advantages:
• Easy concept, where cash flows are real and easy to think about, they are not affected by accounting rules
• Familiratiy, where is a straigt application of the familiar discounted cash flow technique.
Disadvantages:
• Free cash flow does not mesure value added in the short run; value gained is not match with value given up.
• Free cash flow fails to recognize alue generated that does not involve cash flows
• Cash flows from operations (Value added) is reduced by investments (which also add value) investments are treated as value losses
• Forecast-flow-based valuation works best when expected future post horizon flow are positive and growing at a constant rate. Largely because of the problemes listed above, free cash flow based valuation often requires forecast for long horizons, particulary if substantial growth/investment (and therefore large negative free cash flow) is epected in immediate future years.
• It may be difficuilt to use such forecast of negative free cash flwos as a basis for valuation involving continuing value terms.
Explain the relationship between free cash flow , net operating income and net operating assets
- Free cash flow = Operating Income – Change in net operating assets
- That is, free cash flow is operating income (in a reformulated income statement) less the change in net operating asset in the balance sheet.
- Free cash flow in this context can be seen as a dividend from operating cash from operations cash from operating profits after retaining some of the profits as assets
Explain the relationship between free cash flow, net financial assets, net income and dividends
Free cash flow = change in Net financial assets – Net financial income + dividends
