# FCF: any rule-of-thumbs to simplfy calculation?

Hey AF,

I’ve been having a little trouble with DCF analysis specifically with free cash flow. Although I feel comfortable with the analysis, the formula, and methods, I always seem to miss or not include vital information when trying to implement it in an actual case.

For example, I was helping my friend with a Harvard Business Case and felt unconfident with the final result. After some research, I pinpointed my weakness to trouble with identifying data to include in calculate Free cash flow. When should I start with CFO? Should i use CFI as net investment? or start with operations after dep, adjust, and deduce only purchase of Property, Plant and Equiptment. There are so many different terminologies and each source online offers alternative way of calculating it. No straight method.

Do you guys have any rules-of-thumbs in calculating FCF, or techniques to simplfy the matter?

Thanks!

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The way I’ve always thought about it (its been about 12 months since I last did a DCF, so I may be missing nuance), but I just added back non cash expenses and subtract expenses that occured but were not fully expensed.  Lots of ways of doing this, but that’s conceptually how I viewed it.

Just do CFO-CapX=FCF (interest expense is usually small, but you can add ti back to get FCFF)

booyaaa…. figured it out. Just needed a bit of mathematics and playing around with the data…. I used CFO - CapX + net borrowing as the main equation and observed how the other equations relate to it. Bascially FCFF is CFO - CAPX + net borrowing…. and FCFE is CFO - CAPX + Interest*(1-T). All other equations and terminologies break down CFO or put Interest*(1-T) somewhere else.

Antticfa wrote:

booyaaa…. figured it out. Just needed a bit of mathematics and playing around with the data…. I used CFO - CapX + net borrowing as the main equation and observed how the other equations relate to it. Bascially FCFF is CFO - CAPX + net borrowing…. and FCFE is CFO - CAPX + Interest*(1-T). All other equations and terminologies break down CFO or put Interest*(1-T) somewhere else.

I think a big source of confusion with cash flow calculations for most people is whether you’re starting off with cash flows to the firm, or cash flows to equity holders. Your FCFF formula (FCFF = CFO - CAPX + net borrowing) looks funny. Why are you adding back “net borrowing” when this is a financing decision and not an operating decision? I You definitely should add back net borrowing for FCFE since borrowing from debt holders is essentially a cash payment for equity holders, but not sure why you’re looking at the add back for FCFF.

Your FCFE formula above is also strange because if you’re starting with CFO and you get there from the indirect method (i.e. starting with net income), then you’ve already accounted for tax-effected interest expense. Why would you add this back when debtholders have priority over equityholders in the capital structure (assuming the firm isn’t going through a restructuring)?

Basically, here’s how I would think about FCF calculations especially if I were doing a HBS case (I have done many of them). Since most of the time these cases are asking you to evaluate free cash flow to the firm rather than just to equity holders, I’d use this formula:

FCFF = EBIT*(1-t) + change in NWC + D&A - capex + other adjustments

That way, there’s no confusion resulting from whether you’re using direct versus indirect method of calculating your cash flows, and you can see clearly from the formula that all the numbers above are the impact of decisions at firm-level and not just for equity holders. Hope this helps…

why would you add back net borrowing? that’s not cash generated from the underlying business…..

Since we’re on this topic…..

I’ve seen models use RoC to project RoE….

RoC is = (NI + Int(1-t))/(D+E)

However they use BV of D & E. my question is, why is BV used and not market value of E? It seems to me that shareholders equity has a lot of sunk costs, and is not really an accurate estimate of the firm’s capital base, whereas market cap does so much more accurately. (assuming PB>1)

Basically, you won’t be paying BVPS to buy an ownership stake in the firm, so why is return on that BV important?

I’ve wondered this too from time to time about BV.  I think part of it is that MV can wander all over the place, whereas BV may be more stable, even if it is biased downwards.  Another issue is that if you use ROC to figure out the intrinsic value of equity, you may not want to use the current price of the equity to figure out the value of that equity.

The usefulness of BV seems to depend on the industry.  It’s important in financials and in airlines (for different reasons), but it isn’t really that important in services that depend on human capital.

You want a quote?  Haven’t I written enough already???

..the book value is the level of capital the business can deploy for their operations so you use that…..

I tried calculating FCFF and FCFE using multiple equations and tried to make each one come to the same result:

FCFE
(EQ 1)  FCFE = CFO - Capex + Net borrowing
(EQ 2)  FCFE = Net income + non-cash charges (income) - Capex +  net borrowing
(EQ X) Net borrowing = net debt financing - debt repayment
FCFF
(EQ 1) FCFF= CFO + (Interest (1-Tax rate)) - Capex
(EQ 2) FCFF = EBIT (1-Tax rate) + non-cash charges(income) - Capex - Inc. in WC
(EQ 3) FCFF = Net income + (Interest (1-Tax rate)) + non-cash charges (income) - Capex - Inc.  in WC
(EQ 4) FCFF = FCFE + (Interest expense (1-tax rate)) - net borrowings
Source:  http://educ.jmu.edu/~drakepp/general/FCF.pdf

I used the data provided in the HBS case and tried to mimic the steps in the source above. I ended up with different results for each equation! When i played around with the numbers and tried to root everything back to CFO… i then managed to do it.

btw, To get Inc. in Working capital… i just used part of CFO because it contains - inc. in working capital. I pinpointed the parts (like increase in account recievables) and just summed up what it gave. It already did all the work.
Another girl did something different. She did : (Current asset - Current liability this year) minus (current asset - current liability previous year). Using my way got me negative 1400. Using her way got  plus 87000! a big difference!

FrankArabia wrote:

..the book value is the level of capital the business can deploy for their operations so you use that…..

But that’s not actually true. For example say a firm has a plant….cost billions of dollars to be built. In theory that’s in BV at cost. If you paid a lot, your carrying value is higher, and if you paid less, carrying value is lower. However, going forward, it is irrelevant the value of that particular asset…..what is more important is future level of mainetenance expenditure in order to use the asset and interest payments needed to finance it…..

i have no idea what you’re getting at…you asked why you use book value as equity in your calc for ROC…..r

i dont think i understand your question then given all this talk about plant building etc….

Antticfa wrote:

I used the data provided in the HBS case and tried to mimic the steps in the source above. I ended up with different results for each equation! When i played around with the numbers and tried to root everything back to CFO… i then managed to do it.

btw, To get Inc. in Working capital… i just used part of CFO because it contains - inc. in working capital. I pinpointed the parts (like increase in account recievables) and just summed up what it gave. It already did all the work.
Another girl did something different. She did : (Current asset - Current liability this year) minus (current asset - current liability previous year). Using my way got me negative 1400. Using her way got  plus 87000! a big difference!

That’s a huge difference. My guess is that one of you included a particular current asset or current liability that isn’t actually a working capital item. Working capital generally refers to sources/uses of cash for the firm’s every day operations – generally these are things such as inventories, accounts receivable, and accounts payable – but occasionally you have something in the “other” category that is considered current but actually isn’t really a working capital item. Make sure to go through the notes and footnotes and understand what these items are to figure out whether they should be included or not.

-

FCFE = CFO-CapX-NBorrowing

FCFF = CFO-CapX+Int(1-t)

Also in some cases, acquisitions should be considered CapX

Heres the Data: http://i.imgur.com/NOtrH.jpg

How i calculated: 9097 + 6644 + (-15744) + 21707 + (-23139) = -1435 change in net working capital

How she calculated it: (747081 - 329556) - (686686 - 350827) = 81666 change in net worknig capital

I also realized that data from 1998 CFO is 8 month rather than 12 month…  does this have an effect?

thanks!

don’t include cash as a current asset

still does not explain the major difference but i think its because im mixing data with different periods: 12 month and 8 month… will start from the beginning