7.4 Concept 1: Free Cash Flow to the Firm (FCFF)

The starting place for assessing the intrinsic value of a stock is to assess the cash flows a firm can distribute without affecting it's value.  We can break up these cash flows into two important components.  The first is cash that is required to sustain the value of the firm’s investment decisions. we will refer to as “Capital Expenditure.”  This is the expenditure made to support the capacity of the firm to generate goods and services and results from purchases of real assets.

The second is cash that can be distributed by the firm without affecting the firm’s value.  We call this “Free Cash Flow to the Firm (FCFF).”  This is the cash generated from producing the goods and services net of the firm's capital expenditures. 

Both Captial Expenditure and the Free Cash Flows are estimated from the firm's financial statements.  Usually the easiest statement to work with for this purpose is the cash flow statement but these concepts can also be estimated from the balance sheet and income statements.  In this topic we introduce the base form of these important concepts and then present variations in the next few topics.

Capital Expenditure (CAPEX)

The best source of information for CAPEX is the Consolidated Statement of Cash Flows.  This statement reconciles the closing balance of cash and marketable securities with the opening balance of cash and marketable securities by organizing changes into three sets of activities:  operating, investing and financing.  CAPEX can be identifies from a subset of the investing activities that relate to the cost of acquiring additional real assets.

Example:  Calculating CAPEX from the Cash Flow Statement

Suppose the investing activities are provided as follows for technology firm:

CAPEX equals the sum of Payments for property, plant and equipment plus Investment in software = 4108 + 559 = 4667.

If the Cash Flow Statement is not available a reasonable proxy for CAPEX can be calculated by reconciling the change in real assets.  That is, suppose CAPEX primarily arises from Property, Plant and Equpment (PPE) then CAPEX can be computed indirectly as follows:

CAPEX = Closing Balance of PPE less Opening Balance of PPE + Depreciation Expense

Similar adjustments can be made for other real assets on the balance sheet.

Free Cash Flow to the Firm (FCFF)

Free Cash Flow to the Firm can be expressed in various equivalent ways depending on where you start.  For example, you could start with Cash flow statement using Cash Flow from Operations or the Income Statement using either Net Income or EBIT (Earnings before Interest and Taxes) or EBITDA (Earnings before Interest, Taxes Depreciation and Amortization).  The approaches are equivalent, as shown in the following sections.  Usually, the easiest starting place is again to compute this from the Cash Flow Statement.

Cash Flow from Operations Form of FCFF

An accounting cash flow statement is presented in three sections:  cash flow from operations, cash flow from investing activities, and cash flow from financing activities.  We start with cash flow from operations and then compute free cash flow to the firm by adjusting for cash outflows from investing activities referred to as capital expenditure. 

FCFF = Cash Flow from Operations – Cash Flow from Investing Activities (Capital Expenditures (CAPEX))

The above requires one additional adjustment to account for how interest expense is treated in a cash flow statement, as described next.

Because interest expense is classified as an operating activity under US GAAP the accounting number for cash flow from operations taken from a cash flow statement must be adjusted when computing the FCFF.  That is, Interest Expense net of tax should be added back.  IFRS may or may not require this adjustment depending upon how the cash flow statement has been prepared.  This is because IFRS permits the choice as described above.  If FCFF requires this adjustment, you do it as follows:

FCFF = Cash Flow from Operations + Interest*(1 – Tax Rate) - Capital Expenditures (CAPEX)                                                                         1)

Recall from Chapter 4 that the appropriate discount rate for the firm as a whole was the after tax weighted average cost of capital (WACC).   The after tax adjustment for interest expense is consistent with the actual cash flows, given that interest expense is tax deductible, and similarly is consistent with the application of WACC to FCFF if we were discounting future FCFF. 

In this text we will use the shorter notation Interest*(1-t₀) for Interest*(1 – Tax Rate).