FCFF = CFO + interest * (1 - tax rate) - FCInv FCFE = CFO + Net Borrowing - FCInv My question is if we are including net borrowing in the FCFE shouldnt the FCFF be analogous in that it should also include Net Borrowing and also the funds from stock issuance. Theoretically this is the cash available to the firm. Also why do we include net borrowing in FCFE. Shouldnt it be just the CFO - FCInv. I am losing my mind over this. Can some one clarify both of these in real simple terms bearing in mind that I am totally new to the finance world. Thanks
The FCFF is an estimate of free cash flow available to all investors (both stockholders and bond holders) after the company buys and sells its products, pays all cash operating expenses (including tax, but not including interest) and provides services. CFO – in the indirect method starts with Net Income and since NI is a Income statement item - taxes are included - as also is interest expense. Since the FCFF is cash available to all investors - After tax interest expense is added back. CFO calculation already includes the component of Working Capital. Only FCInv - which is a part of the CFI calculation is missing. Hence - CFO + Interest (1-T) - FCINV = FCFF. Now when it comes to FCFE - --> FCFF is used to pay interest expense to service the Bond holders. Additionally company may have borrowed more money from debt holders and also paid back some principal on its existing debt. So Net Borrowing = New Borrowings - Payment of Principal. Again - you are starting with the CFO (and Interest expense has already been taken care of there --> since in the indirect method you started with Net Income). Net Borrowing is a part of CFF. So FCFE = CFO - FCINV + Net Borrowing. Hope this helps.
so cp since we added net borrowings in the fcfe, why cant we add the the net borrowings and the cash from stock issuance to the FCFF. even that is available to every one right. that is where the confusion arises in the first place. also why is only a part of the CFI included in the calculation. why not the entire CFI is included.
It is a sequencing in the various events. Revenues -> Pay for WCINV, FCINV, Cash Operating Expenses, incl. Tax, excl. Interest --> Gives you FCFF From FCFF - Pay Interest expense to Bond Holders get new Net Borrowings --> Get FCFE Read up FCFF and FCFE in the books, before you make statements like the above. The definitions of FCF (whether FCFF or FCFE) are givens. And just because you say something must be so, it does not happen. Remember that the Bond Holders (creditors) are the first people who get the proceeds from the company in case of liquidation. And that is kind of the model that the above is saying as well.
The CF here in think is the available of cash for stock holder and bond holder from the ordinary business of the firm. It include the net CF in fixed capital but not the CFI because some CF in CFI like marketable securities are irrelevant. We add net borrowing and subtract current debt payment to find the CF that available for stockholder in the FCFE since the firm could use the new debt to pay dividend.
company would never use the new debt to pay dividends. Dividends are a part of the profits of the company distributed to existing shareholders (partners) in the firm for their confidence in the firm. What you are suggesting is just what has caused the credit bubble burst in the US - use one Credit card to pay down the amount on another credit card… Remember - Stockholders are the last to get any component of the proceeds from liquidation sale of a company in case of bankruptcy. First folks who are paid are the creditors (who are the debt iissuers). For the support stockholders give the company by investing in the company - (by buying its shares) - they can elect management on the company (hire and fire management). This is the only benefit they get. In good times, they get compensated by dividends from the firm. No company that is in its sane mind would take on extra debt - and then pay shareholders with that debt.
> No company that is in its sane mind would take on extra debt - and then pay shareholders with that debt. In reality, this happens all the time. In the general case, as a firm grows, it takes on new debt proportional to its increasing market cap. At the same time it’s paying dividends. In specific situations, all sorts of companies undertake leveraged recaps (taking on debt solely to distribute proceeds to shareholders.)
Darien I am trying to draw a distinction above between Company A is making Profits - distributing dividends out of that profit. Need funds to grow business - so take on more debt vs. Company B - does not make profits. Takes on extra debt and pays dividends to keep up its image as a profitable dividend distributing company. In Company A’s case - there is a component of sustainable growth (because there are profits and it is earning an ROE). Additionally, company is leveraged so its profits (and losses, when it has them) are magnified due to its financial leverage. Company B is in an unsustainable state - and chances of financial distress are much higher for this company.
> Company B - does not make profits. > Takes on extra debt and pays dividends to keep up its image as a profitable dividend distributing company. This also occurs regularly. For example, look at any of several large US financial institutions recently. CFOs will bend over backward to protect dividends – taking on debt, canceling profitable projects, etc. There’s considerable literature to this effect. > Company B is in an unsustainable state - and chances of financial distress are much higher for this company. You’re confusing an intermittent downturn with financial distress – very different things. If a company is “unsustainable”, then its chances of financial distress are 100% (by definition) – and no one will lend them money to see them pay dividends. So we’re not talking about that case.