what is the difference between the 2 calculation methods? Why does 1 start with Net Income and 1 with CFO? The key difference here is Working Capital Investment…what is the explanation of this?
Do you mean the difference between FCFF and FCFE? Regarding, starting with CFO or NI is the same thing. NI plus non-cash charges (e.g. depreciation, amortization) gets you CFO anyways. So, the 2 below are same 1. FCFF = CFO + … 2. FCFF = NI + Non-Cash charges + …
I agree with rus1bus is saying. It doesn’t matter whether you start with NI or CFO, the formulas give the same result. I don’t think the formula is very important for Level I though. Try to focus on understanding the conceptual meaning. For example, FCFF disregards financing expenses as it “values” cash flows generated by a project (firm) to all stake holders. For example, if you decide to buy the firm and don’t issue debt, FCFF is most relevant for you. On the other hand, if you own a small portion of the firm, you only care about FCFE.
Ok…thanks. What is the logic behind adding back Net Interest (interest expense * 1- tx)?
it’s because FCFF is to the whole firm which is before paying interest to the Bond holders. Tax effect needs to be removed, as company gets tax advantage when it pays interest.
sasankm is correct. FCFF is for the firm. And Bondholders and Equity holders both are considered part of the firm. So, Free Cash Flow to the firm is Cash Flow before paying Interest to Bond Holders and before paying Dividends to Equity Holders. NI is already before paying any Dividends, so no need for any dividend adjustments to NI. But NI has already deducted Interest Payments. They need to be added back after taking care of the tax effect.
understood. thanks again guys. One note on the tax portion; the reason why they add the after tax interest cost is because we are adding this item to Net Income which has already deducted taxes. If we simply added interest expense then we would be adding back too much.
Another way of achieving the same objective is to go back to EBIT and apply the applicable taxt rate and remove that amount. Following example will clear this, Sales 100 COGS 20 EBIT 80 Int. 20 EBT 60 Tax 18 (30%) NI 42 SO, to find out FCFF, we need to add post tax interst (20*.7) 14 to NI. So, FCFF is 56. Otherwise, you can apply applicable tax rate to EBIT (80 *.7) = 56, and get the same FCFF. Hope it helps.
In order to reconcile NI to CFO, NI is adjusted for the following 3 1) Any non-operating activities - such as gain/loss from selling 2) any non-cash items - such as depreciation 3) change in working capital items - such as inventory,AR,AP differences