Buyback does not distort the free cash flow?

CFA Level I
#1

Could anybody help with a question on page 594 of the third book?

Why is stock bought back on the open market least likely to cause a distortion in the true free cash flow of a company assuming that a large stock buyback has taken place to offset the dilutions from options excercised?

Thanks!

#2

Because stock buybacks are one of the uses for free cash flow. It’s a payoff method to shareholders, and does not affect the company’s ability to generate cash flow assuming the buybacks were timely and justified.

#3

Thank you. The formula to calculate the free cash flow is: EBIT (1-Tax rate)+Depreciation&Amortization - Change in Net Working Capital - Capital Expenditure. If the stock is bought back, cash should be decreased, hence net working capital is reduced. So, the free cash flow is actually decreased no matter when the buyback happens, right?

And, I don’t know why choice b and c are wrong.

B. Classifying the cash expended to buy back stock as a financing activity

C. Classifying the tax benefit of opion excercises as an operating cash flow.

#4

The free cash flow to firm AND to equity (FCFF, FCFE) are both BEFORE stock buybacks.

Cash is not part of net working capital, whatever that means. A decrease in the account of ‘cash’ has to be reflected in the cash flow statement, but is not nessecarily part of the FCFF/FCFE calculation. The main changes in net working capital are changes in inventory, recivables and payables.

Distributing cash to shareholders in the form of dividends or buybacks come from the excess of cash for the period, which is the FCFE.

1 Like
#5

Thank you. I think I understand choice A now. But choice B and C seem not to distort the FCF either. why not choose B or C as the answer?

#6

You haven’t posted a question.

Is it “Which of the following is least likely to cause a distortion in the true free cash flow of a company?”.

#7

the question is

What’s least likely to cause a distortion in the true free cash flow of a company assuming that a large stock buyback has taken place to offset the dilutions from options exercised?