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Free Cash Flow to the Firm (FCFF)- How FCFF is calculated

FREE CASH FLOW TO THE FIRM (FCFF), HOW FREE CASH FLOW TO THE FIRM IS CALCULATED, FCFF FORMULA WITH EXAMPLE

1. What is Free Cash Flow to the Firm (FCFF)
2. How Free Cash Flow to the Firm (FCFF) is calculated?
3. Calculation of FCFF- Example
4. Components of FCFF formula- Adjustments from EBIT to FCFF
• Tax Projections
• Depreciation Projections
• Amortization Projections
• Capital Expenditure Projections
• Change in Net Working Capital Projections

1. What is Free Cash Flow to the Firm (FCFF)?

FCFF is the cash generated by a company after paying all cash operating expenses and associated taxes, as well as the funding of Capex and working capital, but prior to the payment of any interest expenses. In corporate finance, free cash flow to the firm (FCFF) is the amount by which a business’s operating cash flow exceeds its working capital needs and expenditures on fixed assets (known as capital expenditures).

It is that portion of cash flow that can be extracted from a company and distributed to creditors and securities holders without causing issues in its operations. As such, it is an indicator of a company’s financial flexibility and is of interest to holders of the company’s equity, debt, preferred stock and convertible securities, as well as potential lenders and investors. FCFF is independent of capital structure as it represents the cash available to all capital providers (both debt and equity holders).

2. How Free Cash Flow to the Firm (FCFF) is calculated? (EBIT to FCFF)

In a Discounted Cash Flow (DCF) analysis, EBIT typically serves as the springboard for calculating FCFF. To bridge from EBIT to FCF, several additional items need to be determined, including the marginal tax rate, Depreciation& Amortization, CAPEX, and changes in net working capital.

EBIT to FCFF

 EBIT Less: Taxes (at the Marginal Tax Rate) EBIAT Add:  Depreciation and Amortization Less: Capital Expenditure Less: Increase/ (Decrease) in Net Working Capital Free Cash Flow to the Firm (FCFF)
Where
• EBIT- Earnings Before Interest and Tax
• EBIAT- Earnings Before Interest After Tax

3. Calculation of FCFF- Example

Question

From the information given below, calculate the Free Cash Flow to the Firm (FCFF) of FitBond company from 2022 to 2026.

Projected Income Statement (US\$ in millions)

 Year 2022 \$ 2023 \$ 2024 \$ 2025 \$ 2026 \$ Revenue 6.7 33.1 55.9 76.0 99.3 Total Direct Expenses 1.8 11.7 19.1 21.9 22.7 Gross Profit 4.9 21.4 36.8 54.1 76.6 Total Indirect Expenses 4.8 10.0 13.9 16.5 18.9 EBITDA 0.0 11.4 22.8 37.6 57.8 Depreciation and    Amortizations 0.9 0.4 0.4 0.4 0.1 Finance Costs 0.0 0.0 0.0 0.0 0.0 Taxation – Global 0.0 2.2 4.5 7.4 11.5 Profit After Tax (PAT) -0.9 8.8 17.9 29.7 46.2
 Capital Expenditure -1.7 0 0 0 0 Change in Net Working Capital -0.2 0.2 0.2 0.1 0.1

Calculation of Free Cash Flow to the Firm (FCFF) (US\$ million)

 Year 2022 \$ 2023 \$ 2024 \$ 2025 \$ 2026 \$ Revenue 6.7 33.1 55.9 76.0 99.3 Free Cash Flow to the Firm (FCFF) EBIT -0.9 10.9 22.4 37.2 57.7 Less: Cash Taxes 0.0 -2.2 -4.5 -7.4 -11.5 Net Operating Profit After Tax (NOPAT) -0.9 8.8 17.9 29.7 46.2 Add:  Depreciation and Amortization 0.9 0.4 0.4 0.4 0.1 Less: Capital Expenditure -1.7 0.0 0.0 0.0 0.0 Less: Change in Net Working Capital -0.2 0.2 0.2 0.1 0.1 Unlevered FCFF -1.9 9.3 18.5 30.3 46.3

4. Components of FCFF Formula- Adjustments from EBIT to FCFF

a. Tax Projections

The first step in calculating FCFF from EBIT is to net out estimated taxes. The result is tax-effected EBIT, also known as EBIAT or NOPAT. This calculation involves multiplying EBIT by (1 – t), where “t” is the target’s marginal tax rate. A marginal tax rate of 35% to 40% is generally assumed for modelling purposes, but the company’s actual tax rate (effective tax rate) in previous years can also serve as a reference point.

b. Depreciation & Amortization Projections

Depreciation is a non-cash expense that approximates the reduction of the book value of a company’s long-term fixed assets or property, plant, and equipment (PP&E) over an estimated useful life and reduces reported earnings. Amortization, like depreciation, is a non-cash expense that reduces the value of a company’s definite life intangible assets and also reduces reported earnings.

c. Amortization

Amortization differs from depreciation in that it reduces the value of definite life intangible assets as opposed to tangible assets. Definite life intangible assets include contractual rights such as non-compete clauses, copyrights, licenses, patents, trademarks, or other intellectual property, as well as information technology and customer lists, among others. These intangible assets are amortized according to a determined or useful life.

d. Capital Expenditures Projections

Capital expenditures are the funds that a company uses to purchase, improve, expand, or replace physical assets such as buildings, equipment, facilities, machinery, and other assets. Capex is an expenditure as opposed to an expense. It is capitalized on the balance sheet once the expenditure is made and then expensed over its useful life as depreciation through the company’s income statement. As opposed to depreciation, capital expenditures represent actual cash outflows and, consequently, must be subtracted from EBIAT in the calculation of FCFF (in the year in which the purchase is made).

e. Change in Net Working Capital Projections

Net working capital is typically defined as non-cash current assets (“current assets”) less non-interest-bearing current liabilities (“current liabilities”). It serves as a measure of how much cash a company needs to fund its operations on an ongoing basis. All of the necessary components to determine a company’s NWC can be found on its balance sheet.

Current assets and current liabilities components

 Current Assets Current Liabilities Accounts receivables Accounts payable Inventory Accrued liabilities Prepaid expenses and other current assets Other current liabilities
Calculation of Net Working Capital

The change in NWC from year to year is important for calculating FCFF as it represents an annual source or use of cash for the company. An increase in NWC over a given period (i.e., when current assets increase by more than current liabilities) is a use of cash. This is typical for a growing company, which tends to increase its spending on inventory to support sales growth. Similarly, A/R tends to increase in line with sales growth, which represents the use of cash as it is incremental cash that has not yet been collected. Conversely, an increase in A/P represents a source of cash as it is money that has been retained by the company as opposed to paid out.

As an increase in NWC is a use of cash, it is subtracted from EBIAT in the calculation of FCFF If the net change in NWC is negative (source of cash), then that value is added back to EBIAT.

The relationship between the change in NWC and free cash flow is as follows:

• Increase in NWC → Less FCFF
• Decrease in NWC → More FCFF

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