Key Rule 2

Question 1

Key rule 2:
Calculating and projecting FCF

Answer 1

Free cash flow is how much after-tax cash flow the company generates on a recurring basis, after taken into account, non-cash charges, changes in operating assets and liabilities, and required CapEx

Question 2

Why calculate and use FCF in a DCF

Answer 2

As it closely corresponds to the actual cash flow that you as the investor, would receive each year if you bought the entire company
- far more accurate than metrics like Net Income and EBITDA, as those leave out CapEx and working capital changes.

Question 3

How do you project FCF

Answer 3

First decide which kind of FCF you need, unlevered or levered. Usually Unlevered FCF, which is good as it is easier to calculate.

Question 4

Step 1 Unlevered FCF

Answer 4

Project company’s revenue growth, i.e., percentage it grows revenue by each year over that projection period. From this, can determine the company’s projected annual revenue based on the most recent historical numbers.

Question 5

Step 2 Unlevered FCF

Answer 5

Need to assume an operating margin for the company so that you can calculate its EBIT, or Opersting income each year.
- usually based on historical margins
- if they have 1 billion in revenue, and a 30% EBIT margin, that’s 300 million in EBIT

Question 6

Step 3 Unlevered FCF

Answer 6

Apply company’s effective tax rate to calculate net operating profit after tax, or NOPAT. If tax rate is 40%, then NOPAT is £180 million

Question 7

Step 4 Unlevered FCF

Answer 7

Then move to CFS, and project 3 key items there which impact FCF: Non-Cash Charges, Changes in Operating Assets and Liabilities, and CapEx

Question 8

Step 5 Unlevered FCF

Answer 8

Main non-cash charges are DnA, may project others, like stock-based compensation.

Add them back because you want to reflect how the company has saved on taxes, make these a percentage of revenue

Question 9

Step 6 Unlevered FCF

Answer 9

You estimate the change in operating assets and liabilities
- if operating assets increase more than operating liabilities, needs extra cash to fund that, so it reduces cash flow.
- make a % of revenue, and subtract this

Question 10

Step 7 Unlevered FCF

Answer 10

Estimate CapEx each year, which reduces cash flow, might average previous years’ numbers, assume a constant change, or make it a % of revenue, subtract cash flow by CapEx by this amount.

Question 11

Let’s say that Accounts Receivable goes up by $10 and Inventory goes up by $10 and on the other side, Deferred Revenue goes up by $10. How does cash change here?

Answer 11

Assets up 10, so cash flow -10.

Changes to working capital = -10

Question 12

Now let’s say that AR goes down by $10, Inventory goes up by $10, Prepaid Expenses goes down by $10, and on the other side Accounts Payable goes up by $10 and Deferred Revenue goes up by $10.

Answer 12

Assets down -10, liabilities up 20, so -30.

So cash flow is up 30

Question 13

You exclude cash because

Answer 13

You’re calculating the change in cash at the bottom of the CFS
- also exclude ST and marketable securities because those count as investing activities and are normally one-ima purchases or sales
- exclude all debt as that is a financing activity

Question 14

how does this calculation change if we’re using Levered Free Cash Flow (Free Cash Flow to Equity) rather than Unlevered Free Cash?

Answer 14

• Need to subtract interest expense and add interest income right after you calculate EBIT
• need to subtract mandatory debt repayments after you subtract CapEx, so if the company must repay, would be subtracted in Levered FCF calculation
• projecting Levered FCF can be considerably more time-consuming because need to know how the company’s debt and cash balance change from year to year, and then hunt to find required debt repayments.