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1here are dlfferenL ways of calculaLlng Lhe lCl dependlng on wheLher one ls lnLeresLed ln
Lhe value of Lhe flrm's equlLy or Lhe value of Lhe enLlre flrm. ln Lhe prlor case, Lhe cash flow
Lo equlLy should be used, and ln Lhe laLLer, Lhe cash flow Lo Lhe company ls Lhe correcL lnpuL.
We are lnLeresLed ln Lhe LoLal flrm value, so Lhe cash flow Lo boLh debL and equlLy holders ls
whaL we seek. 1hus, we sLarL wlLh Lhe Larnlngs 8efore lnLeresL and 1axes (L8l1) whlch ls also
called Lhe operaLlng proflL. 1he L8l1 ls [usL above Lhe lnLeresL expenses ln Lhe lncome
sLaLemenL. lrom Lhe L8l1 we have Lo deducL Lhe Laxes. 1he effecLlve Lax raLes can be lower
Lhan Lhe marglnal Lax raLes lf a company has loss carry forwards, Lax credlLs or lf Lhe flrm
defers Laxes, none of whlch can be susLalned ln perpeLulLy. We use Lhe marglnal Lax raLe and
Lhen compensaLe for Lax savlngs afLerwards. lor mulLlnaLlonal flrms, we calculaLe a
welghLed average of Lhe marglnal Lax raLes uslng Lhe proporLlon of earnlngs ln Lhe flrm's
LoLal earnlngs as Lhe welghL for each counLry. 1he problem wlLh Lhls approach ls LhaL Lhe
welghLs may change over Llme. lf we belleve LhaL Lhls alLers slgnlflcanLly our pro[ecLed cash
flows, we have Lo keep Lhe dlfferenL lncome sLreams separaLed and apply Lhe approprlaLe
Lax raLe Lo each. AnoLher approach ls Lo assume LhaL Lhe lncome generaLed ln oLher
counLrles ls evenLually repaLrlaLed Lo Lhe company's homeland. 1hen Lhe flrm pays Laxes
accordlng Lo Lhe marglnal Lax raLe LhaL applles ln lLs counLry of orlgln and Lhls raLe ls
appllcable Lo all of lLs lncome sLreams. 8y deducLlng Laxes from Lhe operaLlng lncome, we
obLaln Lhe neL CperaLlng roflL AfLer 1axes (nCA1).

1he effecLlve Lax raLe used Lo compuLe nCA1 ls slmply glven by Lhe amounL of Laxes pald
by Lhe company dlvlded by Lhe company's Larnlngs 8efore 1ax ln absoluLe value.

1o Lhe nCA1 we add back Lhe depreclaLlons and amorLlzaLlons (u&A), slnce Lhey are noL
acLual cash flows. uepreclaLlon and amorLlzaLlon cosL reflecLs Lhe wear and Lear of Lhe
company's roperLy, lanL and LqulpmenL (&L) and ls only an accounLlng measure, Lhe
company doesn'L pay ouL any money Lo cover Lhls expense. 1he amounLs are easlly found ln
Lhe company's flnanclal sLaLemenLs. When forecasLlng, lL ls sLralghLforward Lo compuLe Lhe
u&A lf Lhe company follows a clearly deflned lnvesLmenL scenarlo.

nexL, we deducL Lhe CaplLal LxpendlLures (CapLx). 1he currenL value of CapLx can be found
ln Lhe flnanclal sLaLemenLs buL we have Lo forecasL Lhelr amounL for Lhe fuLure. 1he CaplLal
LxpendlLures ofLen come as lump sums. lor example, a flrm may make a huge lnvesLmenL ln


a facLory durlng one year and Lhen only very small lnvesLmenLs over Lhe followlng years. We
generally normallze Lhe CaplLal LxpendlLures by Laklng Lhe average over an lnvesLmenL cycle
(normally around 3 years). 1he average CapLx as a percenLage of Sales or u&A ls ofLen used
Lo forecasL Lhe expenses ln Lhe fuLure. lL can also be useful Lo look aL Lhe Sales-Lo-CaplLal
raLlo whlch ls equal Lo Lhe flrm's revenue dlvlded by Lhe book value of Lhe caplLal lnvesLed ln
Lhe flrm. lf Lhls raLlo has hlsLorlcally been sLable, we can make Lhe assumpLlon LhaL lL wlll
remaln sLable ln Lhe fuLure and hence we can compuLe Lhe company's fuLure relnvesLmenL
needs relaLlve Lo Lhe revenue growLh. lf Lhe hlsLorlcal records are noL avallable, an lndusLry
average can be used as a proxy. Should Lhe flrm's sLraLegy lnclude slgnlflcanL growLh Lhrough
acqulslLlons and Lhls growLh ls accounLed for ln Lhe revenue forecasLs, Lhe amounL spenL on
Lhe acqulslLlons needs Lo be normallzed and added Lo Lhe CapLx. 8egardlng Lhe growLh
esLlmaLes and fuLure lnvesLmenLs, Lhe reLurn on lnvesLmenLs and growLh are llnked ln a
useful way.

llnally, we have Lo ad[usL Lhe cash flows Lo Lhe changes ln worklng caplLal. Worklng caplLal ls
deflned as Lhe dlfference beLween currenL asseLs and currenL llablllLles. We ad[usL lL by
sLrlpplng ouL cash and markeLable securlLles from currenL asseLs and by sLrlpplng ouL
lnLeresL bearlng debL from Lhe currenL llablllLles. Cash and debL are lncluded when we
calculaLe Lhe cosL of caplLal buL Lhey should noL be lncluded here. 1o esLlmaLe Lhe worklng
caplLal needs ln Lhe fuLure we can calculaLe Lhe average hlsLorlc raLlo of worklng caplLal Lo
sales, usually over 3 years. 1hls ls a good approach lf worklng caplLal exhlblLs no clear Lrend
(elLher lncreaslng or decreaslng over Llme as a percenLage of sales). lf Lhere ls a Lrend, when
Lhe buslness ls changlng, or new lnvesLmenLs and markeLs lncrease Lhe worklng caplLal
needs, a beLLer approach ls Lo conslder Lhe change ln worklng caplLal and dlvlde lL by Lhe
change ln revenues. lf, for example, Lhe revenues lncreased by 100 over Lhe lasL year and
worklng caplLal lncreased by 10, we see LhaL Lhe change ln worklng caplLal ls 10 of Lhe
change ln revenue and we can use Lhls Lo forecasL Lhe fuLure worklng caplLal needs.

1he formula for calculaLlng Lhe free cash flow (lCl) ls Lhen:

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