7.7 EBIT Form of FCFF

Free Cash Flows can be computed in a variety of equivalent ways.  One way is directly from the Non US GAAP number Earnings Before Interest and Taxes (EBIT).  For this method the following notation is again used:

FCFF = Free Cash Flow to the Firm

NI = Net Income after Tax

EBIT = Earnings Before Interest and Taxes

CFO = Cash Flows from Operating Activities

DA = Depreciation and Amortizations

ONCI = Other Non-Cash Items

ΔWC = Change in Working Capital (itemized in the Cash Flow Statement)

This is simple because of the relationship between EBIT and Net Income:

NI = (EBIT – Interest Expense)*(1 – Tax Rate)

tc =  Effective Tax Rate

CAPEX = Capital Expenditure

Calculating FCFF from EBIT

EBIT is related to cash flows from operations (CFO), as measured under US GAAP, as follows:

CFO = NI + DA + ONCI – ΔWC = (EBIT – Interest)*(1 – Tax Rate) + DA + ONCI - ΔWC

Substituting into FCFF and cancelling out the Interest*(1 – Tax Rate) terms we get:

FCFF = CFO + Interest*(1-tc) – CAPEX

FCFF = (EBIT – Interest)*(1 – Tax Rate) + Interest*(1-tc) +  DA + ONCI + - ΔWC – CAPEX

CAPEX can be computed directly from the Investing Activities section of the Cash Flow Statement or it can be computed indirectly by reconciling the change in real assets for the period in terms of Depreciation expense and CAPEX such that, CAPEX equals change in real assets plus Depreciation.