Computing FCFF from net income

FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv

• NI: Net income available to common shareholders. It is the company's earnings after interest, taxes and preferred dividends.

• NCC: Net noncash charges. They represent depreciation and other non-cash charges minus non-cash gains. The add-back of net non-cash expenses is usually positive, because depreciation is a major part of total expenses for most companies.

• Int (1 - Tax rate): After-tax interest expense.
  We add this back to net income because
  • FCFF is the cash flow available for distribution among all suppliers of capital, including the debt-holders, and
  • Interest expense net of the related tax savings was deducted in arriving at net income.
  The add-back is after-tax, because the discount rate in FCFF model (WACC) is also calculated on the after-tax basis.

• FCInv: Investment in fixed capital. It equals to capital expenditures for PP&E minus sales of fixed assets.

• WCInv: Investment in working capital. It equals to the increase in short-term operating assets net of operating liabilities.
  Note that working capital for cash flow and valuation purposes is defined to exclude cash and short-term debt (which includes notes payable and the current portion of long-term debt).
  • Cash and cash equivalents are not taken into consideration, because it is the change in this account that is explained by FCFF.
  • Notes payable and the current portion of long-term debt are also ignored, because these accounts pertain to financing decisions, and FCFF describes operating and investing activities only.

Example

Quinton is evaluating Proust Company for the year of 2004. Quinton has gathered the following information (in millions):

• Net income: $250.
• Interest expense: $50.
• Depreciation: $130.
• Investment in working capital: $20.
• Investment in fixed capital: $100.
• Tax rate: 30%.
• Net borrowing: $180.
• Proust has launched a new product in the market. It has capitalized $200 as intangible asset out of product launch expense of $240.
• During the year, Proust has written down restructuring non-cash charges amounting to $30.
• The tax treatment of all non-cash items is the same as that of other items in the books. There are no differed taxes incurred.

Calculate the FCFF for Proust for the year.

Solution

NCC = Depreciation + non-cash restructuring charges - Cash expense during the year in which they are capitalized = 130 + 30 - 200 = -$40 million.

FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv = 250 + (-40) + 50 (1 - 0.3) - 20 - 100 = $125 million.

Computing FCFF from the statement of cash flows

FCFF = CFO + Int (1 - Tax rate) - FCInv

• CFO: Cash flow from operations.

• Int (1 - Tax rate): After-tax interest expense is added back because interest expense is considered an operating cash flow under U.S. GAAP. Note that the adjustment may be unnecessary under the Internationals Accounting Standards, where interest expense can be treated as either operating or financing cash flow.

• FCInv: Investment in fixed assets. It equals to capital expenditures for PP&E minus sales of fixed assets.

The convenience of this approach to calculation of FCFF is that CFO is already adjusted for non-cash charges and changes in working capital accounts.

Example

Uwe is doing a valuation of TechnoSchaft for fiscal year 2004, using the following information (in millions).

• CFO: $250.
• Depreciation: $80.
• Interest expense: $50.
• Tax rate: 30%.
• Investment in working capital: $60.
• Investment in fixed capital: $240.
• Net borrowing: $180.

Calculate the FCFF for the company for the year.

Solution

FCFF = CFO + Int (1 - tax rate) - Investment in fixed capital = 250 + 50 (1 - 0.3) - 240 = $45 million.

As CFO is given, information on WCInv and non-cash charges is not required.

Noncash charges

If an analyst wants to use an add-back method, the analyst must be careful to add back only non-cash component of such charges. As one example, restructuring charges can involve cash expenditures and noncash charges. For example, severance expense, which is incurred in the same year, should not be added back to net income, because it is a cash charge. On the other hand, a write-down in the value of assets as part of a restructuring charge is a noncash item.

Sometimes non-cash items should be subtracted from, instead of being added back to, net income. Examples are non-cash gains on sale of assets, or reversal of previous restructuring charges.

Particular diligence should be exercised in determining effect of deferred taxes and tax benefits of employee stock plans on FCFF. Deferred taxes generate cash flows only if they are expected to reverse in the future, otherwise they should be added back to net income in calculation of FCFF.

Conversely, employee stock ownership plans generate cash flows only if they are not reversed in the future. Consequently, benefits associated with employee options should be subtracted from net income for the purpose of FCFF forecasting, if their reversal is expected in the near future.

We summarize the common noncash charges that impact net income and indicate for each item whether to add it or subtract it from net income in arriving at FCFF:

Computing FCFE from FCFF

FCFE is the cash flow available to common stockholders.

FCFE = FCFF + Net borrowing - Int ( 1- Tax rate)

• Net borrowing: Borrowing of new debt minus repayment of old debt.
• Int (1- Tax rate): Net distributions to debt-holders need to be subtracted from FCFF to calculate FCFE.

FCFE can be calculated from net income. Recall that FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv. Then:

FCFE = NI + NCC + Net borrowing - FCInv - WCInv

FCFE can be calculated from CFO. Recall that FCFF = CFO + Int (1 - Tax rate) - FCInv. Then:

FCFE = CFO + Net borrowing - FCInv

Finding FCFF and FCFE from EBIT or EBITDA

We know that:

• Net income = (EBIT - Interest expense) (1 -Tax rate) = EBIT(1 - Tax rate) - Interest expense (1 - Tax rate)
• FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv.

If we assume that the only noncash charge (NCC) is depreciation (Dep), it's easy to show the relationship between FCFF from EBIT.

FCFF = EBIT (1 - Tax rate) + Dep - FCInv - WCInv

Similarly, we can show that:

FCFF = EBITDA (1 - Tax rate) + Dep (Tax rate) - FCInv - WCInv

It's also possible to calculate FCFE (instead of FCFF) from EBIT or EBITDA by using FCFE = FCFF - Int (1 - Tax rate) + Net borrowing.

• FCFE = EBIT (1 - Tax rate) - Int (1 - Tax rate) + Dep - FCInv - WCInv + Net borrowing
• FCFE = EBITDA (1 - Tax rate) + Dep (Tax rate) - Int (1 - Tax rate) - FCInv - WCInv + Net borrowing

Example

Watson is planning to value Alcan, Inc. The financial information Watson has assembled for his valuation is as follows (unit: million $. Year: 2004):

• EBIT: 400.
• Interest expense: 150.
• Depreciation: 120.
• Income tax rate: 30%.
• Investment in working capital: 60.
• Investment in fixed capital: 300.

Calculate FCFF for the company.

Solution

FCFF = EBIT (1 - Tax rate) + Dep - FCInv - WCInv = 400 x (1 - 0.30) + 120 - 60 - 300 = 40.