Topic 8: Free Cash Flow Estimation (Part 2) Flashcards
What is Working Capital?
measures how much “long‐term capital” covers the “short‐term operations” of the company.
How is Net Working capital calculated?
Net Working Capital(NWC) = Current Assets – Current Liabilities
What does an increase in NWC mean?
requires extra investment that is to be financed with more long‐term capital (equity or liability), implying a net free cash outflow(FCF decreases)
What does an decrease in NWC mean?
means less need for long‐term funds to cover the funding shortfall, more free cash available for the capital providers, or implying a net free cash inflow, (FCF increases)
What is the Indirect formula for Free Cash Flow(FCF)?
FCF = Earnings Before Interest and Tax(EBIT) x (1 – Tax Rate) + Depreciation – Capital expenditures – Change in Net Working Capital + Terminal cash flow
What is the direct formula for Free Cash Flow(FCF)?
: FCF = (Revenue – Cost) x (1 – Tax Rate) – Capital Expenditure – Change in NWC + Tax Rate x Depreciation + Terminal cash flows
Why do we subtract Capital expenditure(Capex) from Earnings before interest to get to Free Cash flow?
as it uses free cash flow available for debt and equity investors and diverts it back into the business for payment of fixed operating assets, thus lowering the free cash flow to investors.
Why do we subtract change in Net Working Capital (NWC) from Earnings before interest to get to Free Cash flow?
as it uses free cash flow available for debt and equity investors and diverts it back into the business for investment in variable operating assets, thus lowering the free cash flow of investors
Why do we Add Terminal Cash Flows to Earnings before interest to get to Free Cash flow?
as terminal cash flow is comprised of after-tax salvage , and recovering net working capital which increase the free cash flow and shutdown cost which decrease free cash flow, which generally make total terminal cash flow positive thus increasing free cash flow
Why do we add depreciation to Earnings before interest to get to Free Cash flow?
depreciation is a tax-deductible expense that reduces overall tax expense, but is added back after the tax deduction has happened as depreciation is a non-cash expense and was only deducted for tax reasons
What is a Depreciation Tax shield?
The tax saving as a result of deducting depreciation expense from the gross earnings of the firm( EBIT is reduced -> less tax is paid)
How is Depreciation Tax shield calculated?
Tax Rate x Depreciation = Depreciation Tax Shield
