I searched the internet and the following quote came out from a book “Equity Asset Valuation” written by Jerald E Pinto, CFA et al. On page 168 there is a quote that says

*“Because notes payable increased by $50 million ($250 million - $200 million) and long-term debt increased by $25 million ($890 million - $865 million), net borrowing is $75 million.”*

On page 169 there is another memorable quote that says

*“NI = (EBIT - Int) (1 - Tax rate) = EBIT( 1 - Tax rate) - Int( 1 - Tax rate)”*

and similarly a few lines further down

*“NI = (EBITDA - Dep - Int) (1 - Tax rate) = EBITDA( 1 - Tax rate) - Dep( 1 - Tax rate) - Int( 1 - Tax rate)”*

Plug and chug into the formulas

**FCFF = NI + Int( 1 - Tax rate) + Dep - FCInv - WCInv**

and

**FCFE = FCFF - Int(1 - Tax rate) + net borrowing**

That NI is EBIT minus interest rate, and then remove tax, is obvious from the name: EBIT. Similarly, for EBITDTA you deduct Interest and Depreciation/amortization, and then remove tax, to get to NI. That way the first and second formulas are easy to remember.

The authors (Pinto et al) also adds that many tedious calculations necessary to adjust when starting form NI aren’t needed when starting from EBIT or EBITDA.

On page 174 the author discusses the debt ratio, or rather **the target debt ratio**. Capital expenditure has two components: those to maintain existing capacity and those for growth. The trick here is to assume that any new fixed capital investment or working capital investment will be partially financed with debt according to the **DR**.

Assume depreciation is the only noncash charge, then

FCFE = **NI + Dep - FCInv - WCInv + net borrowing** {rearrange} is equal to **NI + (FCInv - Dep) + WCInv + net borrowing** and the term **“FCInv - Dep”** is the incremental fixed capital expenditure. The need to forecast net borrowing is now unnecessary thanks to rearranging and realising that part of it is financed with net borrowing according to the DR, so that part “goes away” (cancels out with net borrowing term).

**Net borrowing = DR( FCInv - Dep) + DR( WCInv )**

which means that if DR = 45% then 45% of new investments will be financed with debt. It also means that

FCFE = **NI - (FCInv - Dep) - WCInv + [DR(FcInv - Dep) + DR (WCInv)]** and now with a little algebra = **NI - (1 - DR)(FCInv - Dep) - (1 - DR)( WCInv )**

DR is the percentage of debt to the sum of debt and equity, so it’s D / (D + E) and not D/E (which I actually thought for a split second on a mock exam yesterday)!

Seems to be a good book maybe something to wish for as a present once we’ve cleared this level (Level II)…