Anson Ford Sting Fcff
- Dividends
+/- Common stock issues (repurchases)
After-tax interest expense is classified as financing outflow rather than operating outflow
Calculating FCFF from EBIT. FCFF can also be calculated from earnings before interest and taxes (EBIT):
FCFF = [EBIT x (1 - tax rate)] + Dep - FCInv - WCInv where:
EBIT = earnings before interest and taxes Dep = depreciation
If we start with earnings before interest and raxes (EBIT), we have to add back depreciation because it was subtracted out to get to EBIT However, because EBIT is "before interest and taxes" we don't have to take out interest (remember that its a financing cash flow). We do have to adjust for taxes, though, by computing after-tax EBIT, which is EBIT times one minus the tax rate. We also make the same adjustments as we did before by subtracting our fixed capital and working capital investment.
Professor's Note: Because many noncash adjustments occur on the income statement below EBIT, we don't need to adjust for them when calculating free cash flow if we start with EBIT. We assume that the only noncash charge that appears above EBIT is depreciation in the equation "FCFF from EBIT " In general, however, the rule is to adjust for any noncash charge that appears on the income statement above the income statement item you're starting with.
Calculating FCFF from EBITDA. We can also start with earnings before interest, raxes, depreciation, and amortization (EBITDA) to arrive at FCFF:
FCFF = [EBITDA x (l - tax rate)] + (Dep x rax rate) - FCInv - WCInv where:
EBITDA = earnings before interest, taxes, depreciation, and amortization
Remember that EBITDA is "before depreciation," so we only have to add back the depreciation tax shield, which is depreciation times the rax rate. Even though depreciation is a noncash expense, the firm reduces its tax bill by expensing it, so the free cash flow available is increased by the taxes saved.
Calculating FCFF from CFO. Finally, FCFF can also be estimated by starting with cash flow from operations (CFO) from the statement of cash flows:
CFO = cash flow from operations
Cash flow from operations is equal ro net income plus noncash charges less working capital investment. We have to add back to CFO the after-tax interest expense to get to FCFF because interest expense (and the resulting rax shield) was reflected on the income statement to arrive at net income. We also have to subtract out fixed capital investment since CFO only includes changes in working capital investment.
Professor's Note: Which formula should you use on the exam? I suggest that, at a minimum, you memorize the first one (that starts with net income) and the last one (that starts with cash flow from operations). That way, given either an income statement or a cash flow statement, you can calculate FCFF. However, don't be surprised if you're required to know the other two as well.
Calculating FCFE from FCFF. Calculating FCFE is easy once we have FCFF:
FCFE = FCFF- I nt x (l - tax rate)] + net borrowing where :
net borrowing = long- and short-rerm new debt issues - long- and short-term debt repayments
If we start with FCFF, we have to adjust for the two cash flows to bondholders to calculate FCFE: the after-tax interest expense and any new long- or short-term borrowings. We only subtract the after-tax interest expense because paying interest reduces the firm's tax bill and reduces the cash available to the shareholders by the interest paid minus the taxes saved.
Calculating FCFE from net income. We can also calculate FCFE from net income by making some of the usual adjustments. The two differences between this "FCFE from net income" formula and the "FCFF from net income formula" are (I) after-tax interest expense is NOT added back and (2) net borrowing is added back.
Calculating FCFE from CFO. Finally, we can calculate FCFE from CFO by subtracting out fixed capital investment (which reduces cash available to shareholders) and adding back net borrowing (which increases the cash available to shareholders).
FCFE = CFO - FCInv + net borrowing Free Cash Flow With Preferred Stock
The FCFF and FCFE formulas assume that the company uses only debt and common equity to raise funds. The use of preferred stock requires rhe analyst to revise the FCFF and FCFE formulas ro reflect the payment of preferred dividends and any issuance or repurchase of such shares. The thing to remember is to treat preferred stock just like debt, except preferred dividends are not tax-deductible.
Specifically, any preferred dividends should be added back to the FCFF, just as aftertax interest charges are in the net income approach ro generating FCFF. This approach assumes that "net income" is net income to common shareholders after preferred dividends have been subtracted out. The WACC should also be revised to reflect the percent of rotal capital raised by preferred stock and the cost of that capital source. The only adjustment to FCFE would be to modify net borrowing to reflect new debt borrowing and net issuances by the amount of the preferred stock. Keep in mind that relatively few firms issue preferred stock.
Professor's Note: See Questions 6 through 10 in the Concept Checkers at the end of this topic review for specific examples in which we calculate free cash flow for a firm with preferred stock.
LOS 42.e: Calculate FCFF and FCFE given a company's financial statements, prepared according to U.S. generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS).
Let's try an example to see if all these formulas really work. Example: Calculating FCFF and FCFE
Anson Ford, CFA, is analyzing the financial statements of Sting's Delicatessen. He has a 2007 income statement and balance sheet, as well as 2008 income statement, balance sheet, and cash flow from operations forecasts (as shown in the tables below). Assume there will be no sales of long-term assets in 2008. Calculate forecasted free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) for 2008.
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Income Statement | ||
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