I have a question on the FCFF. (free cash flow to firm). It’s computed like this:
FCFF=N.I+NCC+Interest expense*(1-t)-Working Capital Expenditure-Capital Expenditures
Thee kinds of expenses are present in the formula:
Interest expense, working capital expense, and Capex.
-Do those three kinds of expenditures cover all kinds of expenditures a company may incure?
-The interest expense are added (times (1-t)) while the two others expenditures are substracted. Why there is a special treatment for the Interest expense?
FCFF is the pure cash flow remaining to all participants, after settlement all operating and capital expenditures. Those are equity holders, bond holders and preffered stock holders if they exist.
To calculate pure CF in the form of FCFF from NI (the formula what you use), non cash expenses (eg. depreciation) should be added back to CF as well as using tax savings in the form of deductable interest expense +( int.(1-t)). This form +( int.(1-t)) presents tax savings thus lower cash outflows, higher acummulated cash balance.
FCFF can also be calculated from CFO, EBIT and EBITDA using other formulas but with same outcome.
NI is the bottom line of the P&L and it includes all possible expenses and incomes. Since depreciation was deducted at one point you want to add it back, i.e. NI is much larger if we ignore depreciation, which is not cash flow.
Next we go to the balance sheet to check transactions that did not go through P&L. This includes fixed asset purchases, creditor payments etc. Note that we deduct FC and WC expenditures. If we had FC disposals we would add it to NI.
Last, we add back interest (we want to ignore it) because this is money paid to loan holders/bondholders, but they are also part of the balance sheet. FCFF is cash flow available to debtholders as well as the equityholders. So imagine a debtholder and a shareholder standing next to each other and looking at the company FCFF and saying this is cash available to us. “You will take the interest and I will receive the rest” says the shareholder.
The reason interest is added back net of tax is because when interest was deducted to arrive at NI it helped the company pay less tax. So the more interest you pay the less tax you pay and there is a net off.
The most common non-cash expenses are depreciation of fixed assets, amortization of intangibles and financial assets measured through amort.exp., changes in deferred tax position (with prefix - if is net change in DTA), changes in long term provisions and other non cash accruals.
Net Income (starting point) -> however it includes non-cash charges, any cash flow by definition should not include NCC, because e.g. it is already shown as cash outflow from investing if we are talking about PP&E purchase at the time of acquisition - Depn. / Amortisation is just an accounting treatment)
Add : NCC (Added back purely for the reason mentioned above, because we deducted it while arriving at Net Income
Add : Interest Exp. X (1-t) -> since we are calculating FCFF(the cash flow that is available to all stakeholders e.g. Equity holders + Lenders, we ought to add back Interest Exp., we are trying to calculate value of the firm here. However, we get tax benefit while arriving at Net Income -> (Interest is Tax deductible) so we consider only after tax interest. (you can check the maths here and understand that what we are doing is correct)
Less : Inv. in WC & Inv. in Fixed Asset - Obviously we are trying to calculate cash flows available to firm for further distribution / reinvestment, so we have to take care of current and future business requirements, and only the balance is available to stakeholders
When you took Net Income as a starting point, you already took care of all the cash expenses that the firm incurred, so only thing left to do was to negate th impact of non-cash expenses. So this answers your question about “all other expenses”
In terms of Free Cash Flow, I would differentiate between an accounting an a valuation perspective:
(1) From an accounting perspective, Free Cash Flow is “Cash Flow from Operations” minus “Cash Flow from Investing Activities”. Both items are from the cash flow statement. Taken together, they show you the amount of cash that the company generates (for both bond and equity holders) before taking into account financing activities.
(2) From a valuation perspective, you use (1) but you adjust it for the tax shield, i.e. interest expense * tax rate. Why? Because the tax shield is already taken into account in the WACC when discounting (i.e. WACC is lower). Without the adjustment, the tax shield would have been accounted for two times, i.e. numerator too high and denominator already lower because of tax shield.
No, Investments in FA and WC, flow through Balance Sheet and Cahs Flow Statement,
All we are trying to do is to capture all cash outflows (whether exp. routed thru. P&L or Balancesheet)
Another logic for adding back NCC (e.g. Depn. or amortization) is that we already would have accounted it under Cash outflow Investments in Fixed Assets at the time of acquisition and subsequent DEPN. is nothing but the charge (out of that acquisition value) which is routed thru. PnL over the life of the asset (we don’t expense out the Fixed asset immediately thru. PnL, we do it over the life of the asset), you don’t want to double count while calculating FCFF do you?