Free Cash Flow

Free Cash Flow (FCF) is the residual cash flow that's left over after all of the project's requirements have been satisfied and the implications accounted for.

It's the cash flow that can be distributed to the financial claimants (e.g., debt and equity) of the project or company.

It's not the same as accounting cash flow from the statement of cash flows (SCFs) but we can derive free cash flow from the statement of cash flows.

In the previous section, we discussed the NPV rule.

The formula for NPV is actually computed using FCFs (Free Cash FLows), as follows:

$NPV = FCF_0 + \frac{FCF_1}{(1+R)} + \frac{FCF_2}{(1+R)^2} + \frac{FCF_3}{(1+R)^3} + ... + \frac{FCF_T}{(1+R)^T}$

FCF is computed as follows:

$FCF = (Revenue - Costs - Depreciation) * (1-t_c)$ + Depreciation - Capital Expenditures - Change in Net Working Capital

where:

• $t_c$ is the marginal tax rate,

• $(Revenue - Costs - Depreciation) * (1-t_c)$ is also known as the Unlevered Net Income/Net Operating Profit After Taxes (NOPAT)/Earnings Before Interest After Taxes (EBIAT)

• Revenue = Market Size * Market Share * Price

• Costs = Cost Margin * Revenue + R&D Expenditures

• Net Working Capital = Current Assets - Current Liabilities

  • Current Assets = Cash + Accounts Receivable + Inventory

  • Current Liabilities = Accounts Payable

• Change in Net Working Capital = NWC(t) - NWC(t-1), i.e. the change in NWC over one period

The FCF described above is more precisely called unlevered FCF.

Levered FCF or Free Cash Flow to Equity (FCFE):

FCFE is residual cash flow left over after all of the project’s requirements have been satisfied, implications accounted for, and all debt financing has been satisfied.

It is the cash flow that can be distributed to the shareholders (i.e., equity) of the project or company.

$FCFE = FCF - Interest*(1-t_c)$ + Net Borrowing

It is called leveraged because it is affected by the choice of leverage i.e. debt.

Note that strategic decisions affect FCF (and thereby FCFE), whereas financial decisions affect only FCFE, they do not affect FCF.