What are the differences between the following two formulas: 1. FCFE = NI + NCC - FCInv - WCInv + net borrowing 2. FCFE = NI - [(1 - DR) x (FCInv - Dep)] - [(1 - DR) x WCInv], where DR = target Debt-to-Asset ratio From my understanding these are what I can pick out: a) Formula #2 takes into account only the equity portion of FCInv and WCInv since the forecast only pertains to free cash flow to equity b) In formula #2, ‘NCC’ (as stated in formula #1) is not relevant since non-cash charges would not have been taken into account as part of NI? c) In formula #2, ‘net borrowing’ is not taken into account since debt is not part of the equity forecast Questions: A. Are the above statements correct? B. Why doesn’t formula #1 cater for only the equity portion of FCInv and WCInv (similar to formula #2)?
My friend, you either got it wrrong to a certain extent, or I am just net getting you… I already have a thread discussing almost the same thing, only a few days old, but anyway here is what I gota say… First of all regarding the NCC, its not about being taken care in NI or anything like that, in a matter of fact I would say feel free to add NCC to formula one if you want to page 413, they told you “we assume that depreciation is the only noncash charge” so thats all it is, an assumption to simplify things, and if you have reason to belive NCC will exist and you are able to forcast them, should should include them in formula 2 What do you meen net borrowing is not taken into account in formula 2? It is embeded in the way we are paying for Fixedcap and Workingcap…hek if you wana see net borrowing in the formula (if that makes you feel better), remove the (1-dr) from the formula, and now add net borrowing of equal to (working cap invs+fixed cap invest - depreciation)*DR "a) Formula #2 takes into account only the equity portion of FCInv and WCInv since the forecast only pertains to free cash flow to equity " so regarding this statemnt, all there is to it is that formula one is adding net borrowing explictly, and formula 2 is embeding it in another way… sorry if my explanation is messy, ats 3 am and i still got 3 more hours of studying to do… i think if you slow down and read the assumptions and derivations of the formula you WILL get it… else ask and we will try to help 
take care
Thanks for the detailed explanation. Just so that I understand what you are trying to say: formula #2 fully reflects formula #1 given we implicitly reword formula #2 by slightly adjusting for Net Borrowing? If so, then the above formula #2 now becomes: FCFE = NI - [DR * (WCInv + FCInv - Dep)] Is this correct? If so, what happens to the cost of WCInv and FCInv - which we originally negated from NI in formula #1? Note that I didn’t think you meant to add the Net Borrowing adjustment to the original formula #2 - that would completely throw it off.
“Note that I didn’t think you meant to add the Net Borrowing adjustment to the original formula #2 - that would completely throw it off.” yes i did meen to add it, but i said first you remove (1-dr) from inside the formula… so insted of accounting for the new debt with the (1-dr) you add the new borrowing explicty the amount you would need to add to get the same effect is new debt=dr*(fixed cap-dep+working cap) this is just simple math my friend, to me it is as clear as 1+1=2 but maybe i suck at getting the point accross… if this takes you long, move on and know that nothing big is being done there… so basiclly if insted of using formula 2 you opened an excel spread sheet and started to say okay, this year we have this much capx, this much working cap, and we want to borrow 40% of them, and thus add that much to your fcfe, you would get the exact same result god it sucks to watch someone not getting something and being unable to get the point accros lol…
Sorry - may be it’s just me but I was unable to understand your articulation the first time around. So, in essence all that “[DR * (WCInv + FCInv - Dep)]” really means is it’s taking the debt portion out - and if we substitute it for Net Borrowing in formula #1 we end up with formula #2 since ‘total WCInv and FCInv’ minus ‘levered WCInv and FCInv’ gives us equity portion of WCInv and FCInv - ok, now I think I get it. This brings me to the following question I posed earlier: c) In formula #2, ‘net borrowing’ is not taken into account since debt is not part of the equity forecast Technically, this statement is false - however, there is a reason why they restated the equation to formula #2 as they did - and that is probability related to the fact that they are unable to predict the extent of their borrowings and outflow of interest way into the future (even though *assumed* target capital structure exists)? If not, what is the reason behind restating the forecast equation to formula #2?
" In formula #2, ‘net borrowing’ is not taken into account since debt is not part of the equity forecast " I still dont get what you meen by this, net borrowing is taken into account in both equations The first equation subtracts what we have to pay for investments to get to what is available to equity holders. But it also adds the net borrowing because we can use that new money to pay equity holders. Second equation, rather than subtract the full investments, then add net borrwing. You just subtract a smaller portion to account for the fact that you will borrow to cover the rest. So to simplify, say your net income is 20 and you have working cap of 2, fixed cap of 2, dep of 1 you will borrow 40% of your investments you can either say fcfe=20-2-2+1+0.4(2+2-1)=18.2 of fcfe=20-(0.6(2+2-1))=18.2 so again, both formulas are doing the same thing, both are accounting of the fact that you will have new debt avialble to pay to your shareholders… one leaves it up to you to decide how much debt, the other one builds it in with (1-dr) but if you use a debt equal to dr in the first formula basicly the same thing… again my friend, while it is nice to know everything, this is a waste of your time highlight it and think about it after exam, i wasted 100s of hours thinking about such stuff guess what, it will do me nothing on the exam?
Appreciate the reply - but the latest query isn’t about the indifference between the two formulas. We’ve previously established that they are similar, quantitatively or otherwise. The question is a *conceptual* one - what’s the reason behind re-stating the equation to formula #2 when estimating FCFE? My take is that “…the fact that they are unable to predict the extent of their borrowings and outflow of interest way into the future (even though *assumed* target capital structure exists)…” Anyone else able to shed a light on this please?
- FCFE = NI - [(1 - DR) x (FCInv - Dep)] - [(1 - DR) x WCInv], where DR = target Debt-to-Asset ratio This tells you what portion of invested capital (Net PPE + WCInv) will be financed by debt (since equity funding doesnt impact FCFE) If you take the FCFE equation FCFE = NI+ Dep - FCInv - WcInV + Net Borrowings Net Borrowings = DR(FCInv - Dep + WCInv) So FCFE = NI+ Dep - FCInv - WcInV + DR*(FCInv - Dep + WCInv) FCFE = NI+ Dep - FCInv - WcInV + DR*Fcinv - DR*Dep + DR*WCInv FCFE = NI + Dep - DR*Dep - FCInv + DR*Fcinv - WcInV + DR*WCInv FCFE = NI + Dep*(1-DR) - FCInv*(1-DR) - WCInv*(1-DR) FCFE = NI - (1-DR)*(FCInv - Dep)*(WCInv) FCFE = NI - (1-DR)*(FCInv - Dep) - (1-DR)*(WCInv)
Nice post nomad_SA Keep in mind that FCFE is the cash “avalable” to be distributed to the equity holders. How it is actually used is the management’s discretion. your statement below is not true. Debt, in the form of borrowings, becomes a part of FCFE, ie, cash available to equity. So, debt is part of the forecast associated with cash flow to equity. If the firm borrows money (debt), the cash inflow could be used to pay dividends to equity investors, hence becoming cash available to equity. Similarly, operating investments (FCInv, WCInv) are estimated based on the target debt structure of the firm to calculate how much of those investments will be financed by debt, which again, becomes cash available to equity. CFAI text does a great job in deriving the 2nd equation, similar to what nomad_SA has done above. Trekker Wrote: > c) In formula #2, ‘net borrowing’ is not taken > into account since debt is not part of the equity > forecast
Here’s what I’ve come to realize about all of these formulas, and it comes from having taken the test once and having done a lot of EOC’s: Unless you’re a financial genius and you know how to derive all of these formulas from their base concepts, don’t bother. These formulas are given separately because they are all tested separately via the format of each question. From the OP, you’ll be given a question that has the components necessary to answer via formula #1. Sometimes, the question given will have the components necessary to answer using formula #2. It’s just that simple. Like I said - if you have a *very* good understanding of the material, you can work around just a few formulas and come up with the right answer to the problem set. However, given the time constraints, you’re basically being asked to recall a specific formula/concept and apply it as directed.
Awesome - now I think I am beginning to see the light … So, to conclude - the rationale behind restating the formula from THIS: 1. FCFE = NI + NCC - FCInv - WCInv + net borrowing TO THIS: 2. FCFE = NI - [(1 - DR) x (FCInv - Dep)] - [(1 - DR) x WCInv] is to better reflect the equity portion of FCInv and WCInv once debt financing (applied to finance FCInv and WCInv) has been negated - and subtracting this equity portion from NI is essentially what is available to shareholders. And given formula #2 is a formula for forecasting we use the targeted cap structure to obtain the DR. Agreed that derivation of formulas may sound nonsensical at times - and simple application may do the trick for the exam - but for me part of doing all this is to actually *learn* the relationships among them which may drastically curtail the learning curve for other similar/related formulas in the future