FREE online courses on Mergers & Acquisitions - Chapter 4 - Free Cash Flow

 

One of the more reliable cash flows for valuations is Free Cash Flow (FCF). FCF accounts for future investments that must be made to sustain cash flow. Compare this to EBITDA, which ignores any and all future required investments. Consequently, FCF is considerably more reliable than EBITDA and other earnings-based income streams. The basic formula for calculating Free Cash Flow (FCF) is:

 

FCF = EBIT (1 - t ) + Depreciation - Capital Expenditures + or - Net Working Capital

 

( 1 - t ) is the after tax percent, used to convert EBIT to after taxes.

 

Depreciation is added back since this is a non-cash flow item within EBIT

Capital Expenditures represent investments that must be made to replenish assets and generate future revenues and cash flows.

 

Net Working Capital requirements may be involved when we make capital investments. At the end of a capital project, the change to working capital may get reversed.

 

In addition to paying out cash for capital investments, we may find that we have some fixed obligations. A different approach to calculating Free Cash Flow is:

 

FCF = After Tax Operating Tax Cash Flow - Interest ( 1 - t ) - PD - RP - RD - E

 

PD: Preferred Stock Dividends

RP: Expected Redemption of Preferred Stock

RD: Expected Redemption of Debt

E: Expenditures required to sustain cash flows