Financial Subject: Free cash flows computation

There are different ways of calculating the FCF depending on whether one is interested in the
value of the firms equity or the value of the entire firm. In the prior case, the cash flow to
equity should be used, and in the latter, the cash flow to the company is the correct input. We
are interested in the total firm value, so the cash flow to both debt and equity holders is what
we seek. Thus, we start with the Earnings Before Interest and Taxes (EBIT) which is also
called the operating profit. The EBIT is just above the interest expenses in the income
statement. From the EBIT we have to deduct the taxes. The effective tax rates can be lower
than the marginal tax rates if a company has loss carry forwards, tax credits or if the firm
defers taxes, none of which can be sustained in perpetuity. We use the marginal tax rate and
then compensate for tax savings afterwards. For multinational firms, we calculate a weighted
average of the marginal tax rates using the proportion of earnings in the firms total earnings
as the weight for each country. The problem with this approach is that the weights may
change over time. If we believe that this alters significantly our projected cash flows, we have
to keep the different income streams separated and apply the appropriate tax rate to each.
Another approach is to assume that the income generated in other countries is eventually
repatriated to the companys homeland. Then the firm pays taxes according to the marginal
tax rate that applies in its country of origin and this rate is applicable to all of its income
streams. By deducting taxes from the operating income, we obtain the Net Operating Profit
After Taxes (NOPAT).

The effective tax rate used to compute NOPAT is simply given by the amount of taxes paid
by the company divided by the companys Earnings Before Tax in absolute value.
To the NOPAT we add back the depreciations and amortizations (D&A), since they are not
actual cash flows. Depreciation and amortization cost reflects the wear and tear of the
companys Property, Plant and Equipment (PP&E) and is only an accounting measure, the
company doesnt pay out any money to cover this expense. The amounts are easily found in
the companys financial statements. When forecasting, it is straightforward to compute the
D&A if the company follows a clearly defined investment scenario.
Next, we deduct the Capital Expenditures (CapEx). The current value of CapEx can be found
in the financial statements but we have to forecast their amount for the future. The Capital
Expenditures often come as lump sums. For example, a firm may make a huge investment in a
factory during one year and then only very small investments over the following years. We
generally normalize the Capital Expenditures by taking the average over an investment cycle
(normally around 5 years). The average CapEx as a percentage of Sales or D&A is often used

to forecast the expenses in the future. It can also be useful to look at the Sales-to-Capital ratio
which is equal to the firms revenue divided by the book value of the capital invested in the
firm. If this ratio has historically been stable, we can make the assumption that it will remain
stable in the future and hence we can compute the companys future reinvestment needs
relative to the revenue growth. If the historical records are not available, an industry average
can be used as a proxy. Should the firms strategy include significant growth through
acquisitions and this growth is accounted for in the revenue forecasts, the amount spent on the
acquisitions needs to be normalized and added to the CapEx. Regarding the growth estimates
and future investments, the return on investments and growth are linked in a useful way.
Finally, we have to adjust the cash flows to the changes in working capital. Working capital is
defined as the difference between current assets and current liabilities. We adjust it by
stripping out cash and marketable securities from current assets and by stripping out interest
bearing debt from the current liabilities. Cash and debt are included when we calculate the
cost of capital but they should not be included here. To estimate the working capital needs in
the future we can calculate the average historic ratio of working capital to sales, usually over
5 years. This is a good approach if working capital exhibits no clear trend (either increasing or
decreasing over time as a percentage of sales). If there is a trend, when the business is
changing, or new investments and markets increase the working capital needs, a better
approach is to consider the change in working capital and divide it by the change in revenues.
If, for example, the revenues increased by 100% over the last year and working capital
increased by 10%, we see that the change in working capital is 10% of the change in revenue
and we can use this to forecast the future working capital needs.
The formula for calculating the free cash flow (FCF) is then:
FCF = +
Net Incr. in Working Capital
With
= (1 )