Hi,
Please explain this formula, especially The last two items in this formula as simply as you can.
FCFF = Net Income + Non-cash charges + Interest exp(1- tax rate) - Change in Fc Inv - Change in WC Inv
Thanks
Change in FC Investment = FCInv Year 1 - FCInv Year 2
Change in WC Investment = WC Inv Year 1 - WC Inv Year 2
and FCInv - could have components of Sale of equipment you already had, and purchase of new equipment
Due to the Sale + Purchase
the Depreciation Term would be affected as well.
In general
Ending Gross PPE = Beginning Gross PPE + Purchases - Sales - (1)
Net PPE = Gross PPE - Accumulated Depreciation - (2)
So in Eqn 1
Ending Net PPE + Ending Accum Depr.= Ending Gross PPE
Beginning Net PPE - Beginning Accum Depr.= Ending Gross PPE
So Ending Net PPE + Ending Accum Depr = Beginning Net PPE + Beginning Accum Depr + Purchases - Sales
Or Ending Net PPE = Beginning Net PPE - Change in Accum Depr + Purchases - Sales
and in the above
Change in Accum Depr = Ending Accum Depr - Beginning Accum Depr
thank you for the info but I need to understand the logic behind it. The logic behind why we subtract change in net working capital and how it affects free cash flow to the firm. Same goes for Change in fixed capital investment and other items in the formula.
cause you’re basically making adjustments to net income which is an accounting number, in order to get a cash number. So when you initially booked to these WC accounts they impacted NI but not cash (dr a/r cr rev)… which is now why you have to reverse out that effect to get to cash. Same goes for fixed assets… it wasn’t originally in NI but it impacts cash so you subtract this amount out.
… at least that’s how i look at it. 
The investment in fixed capital and the investment in working capital are uses of cash necessary to maintain the size of the firm. FCFF is a measure of discretionary cash flow; these investments aren’t discretionary.
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Could you please explain it in more detail S2000magician? So I copy pasted the paragraphs below from some other forum written by an Anonymous person and I didn’t understand the last paragraph.
The logic behind subtracting net working capital is as such: whenever working capital increases on a net basis, it is a use of cash. If the company is growing its current assets from period to period, this requires cash that is then not available to its owners (hence, not “free” cash flow). Growing inventory, accounts receivable, or even just stashing more money in the bank takes away available cash from company owners.
Conversely, if your net working capital is shrinking from period to period, it suggests that more cash is being freed up, which makes it available for distributions to company owners. By subtracting a negative amount, your free cash flow figure grows.
so what about that did you not understand?
I seem to recall you are in Level II - so all this use of cash, source of cash - which is Level I material from the Cashflow statement reading and which this builds upon - should be reasonable to understand.
If WC is increasing from Year 1 to Year 2 - you have used up cash to buy the WC. So WCInv increases.
FCFF subtracts the Increase in WCinv.
- Change in WC Inv (check your equation above).
So FCFF goes down.
s2000 is correct. WC change and FC change are maintenance use of cash therefore they aren’t free flows to capital investors. WC change and FC change specifies the use of cash on balance sheet items. Those expenditures appear on the cash flow statement but not the income statement. An example in an increase in inventory, assuming all other WC accounts are unchanged, will represent a positive WC change, but it’s not on the income statement because the income statement is only capturing COGS.
It’s possible you might be letting the formula confuse you. So, I’m going to write it another way to try and explain it.
FCFF=CFO+Interest Expense(1-T)-FCIncv.
CFO=Net Income+Non-Cash Charges-Change in WcInv. The net income on your income statement is not the only money you made. You also made/lost money from your receivables, inventory, and payable. You need to subtract the change in WC to find out how much money your company made from operations throughout the year, because you made money from decreasing receivables/inventory and increasing payables.
You add in Interest Expense(1-T) because it was subtracted out on the income statement. You want to find out how much money is available to all providers of capital.
Now, the FCInv is saying “after we invest back into our company how much money do we have left over for providers of capital?”
What if the amount of fixed asset decrease year by year, will the adjustment for “investment in fixed capital” be positive?
I keep it straight in my mind by thinking of this: free cash flow to the firm is the cash flow available to ALL providers of capital, let it be creditors, shareholders or preferred shareholders. Investment into working capital and investment into fixed capital are the cash investments we make for our operational assets to keep on going. You make investments in those before you pay off creditors or shareholders, in a perfect world.
A decrease in fixed capital could lead to a negative figure in the equation, adding to FCFF if you sold the assets. That frees up cash available to all creditors and shareholders. A decrease in FC due to depreciation will not since, as you know, depreciation is a non-cash charge. To circle it all up, Ending FC = Beg FC + FC Investment - Depreciation. What they are asking for in the FCFF equation in the FC Investment (use of cash, which is why it’s subtracted in the FCFF equation), not Ending FC - Beg FC, although in a theoretically perfect world with no depreciation, they could be the same thing.
The same logic goes with working capital.
