How do shareholders use Free Cash Flow information? Solution A) A measure of fin

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A) A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt. FCF is calculated as: EBIT(1-Tax Rate) + Depreciation & Amortization - Change in Net Working Capital - Capital Expenditure It can also be calculated by taking operating cash flow and subtracting capital expenditures. Some believe that Wall Street focuses myopically on earnings while ignoring the "real" cash that a firm generates. Earnings can often be clouded by accounting gimmicks, but it's tougher to fake cash flow. For this reason, some investors believe that FCF gives a much clearer view of the ability to generate cash (and thus profits). It is important to note that negative free cash flow is not bad in itself. If free cash flow is negative, it could be a sign that a company is making large investments. If these investments earn a high return, the strategy has the potential to pay off in the long run. B) Operating cash flows (net income plus amortization and depreciation) minus capital expenditures and dividends. Free cash flow is the amount of cash that a company has left over after it has paid all of its expenses, including investments. Negative free cash flow is not necessarily an indication of a bad company, however, since many young companies put a lot of their cash into investments, which diminishes their free cash flow. But if a company is spending so much cash, it should have a good reason for doing so and it should be earning a sufficiently high rate of return on its investments. While free cash flow doesn't receive as much media coverage as earnings do, it is considered by some experts to be a better indicator of a company's financial health. C) The Dividend Decision is a decision made by the directors of a company. It relates to the amount and timing of any cash payments made to the company's stockholders. The decision is an important one for the firm as it may influence its capital structure and stock price. In addition, the decision may determine the amount of taxation that stockholders pay. There are three main factors that may influence a firm's dividend decision: Free-cash flow Dividend clienteles Information signalling The free cash flow theory of dividends----->>>>> Under this theory, the dividend decision is very simple. The firm simply pays out, as dividends, any cash that is surplus after it invests in all available positive net present value projects. A key criticism of this theory is that it does not explain the observed dividend policies of real-world companies. Most companies pay relatively consistent dividends from one year to the next and managers tend to prefer to pay a steadily increasing dividend rather than paying a dividend that fluctuates dramatically from one year to the next. These criticisms have led to the development of other models that seek to explain the dividend decision. D) When valuing the operations of a firm using a discounted cash flow model, the operating cash flow is needed. This operating cash flow also is called the unlevered free cash flow (UFCF). The term "free cash flow" is used because this cash is free to be paid back to the suppliers of capital. E) One of the most important factors to consider when analyzing a company from a fundamental perspective is that company’s ability to generate free cash flow. Cash flow represents the flow of cash earned and spent in a company. This pattern reveals how much money is available in a company at a given time. This is often a key measure of a company’s true health. If a company is paying out expenses faster than it is generating revenue, it can result in poor cash flow. A company’s cash flow is calculated by subtracting the operating earnings figure from the capital expenditures figure. The reason why free cash flow is an important variable to look at is because if the company is experiencing negative flow, then they will have to look elsewhere for funds to even think about growing the business. If, on the other hand, there is an abundance of cash left over, it can then be allocated for growing and expanding the business. By virtue of having a healthy free cash flow situation management has a lot of flexibility in its decision making. They can internally finance new projects or add new product lines and penetrate new markets without the need to go to banks to borrow money or selling additional stock to raise capital. Many times companies borrow their way right into failure or sell so many shares that there is no way they can ever earn enough to justify a higher stock price. The bottom line is that if a company cannot generate free cash flow and eventually become self-financing, it is only a matter of time before growth is stopped, funds cannot be borrowed and, of course, the stock is so low that no one wants to purchase another secondary offering. This is why the free cash flow statistic needs to be closely analyzed by a fundamental analyst. In addition to do internal financing free cash flow allows a company to do other things as well. For instance, it provides companies the ability to pay and increases dividends, which is very important in the stock market now that dividends are only taxed at the 15 percent rate. Given this tax change many fundamental analysts look at a company’s ability to use free cash flow to pay and raise dividends as it is an extremely important factor in the stock market. Another important point to consider is that companies can use their free cash flow to buy back stock, which is certainly beneficial to stockholders. Typically, when a company sees its own shares as an attractive investment this is very positive on a few fronts. First, the amount of shares becomes reduced but the earnings and other numbers remain the same. This means the price-to-earnings ratio, PE to growth rate, price to sales, and other key financial ratios will all become lower and attract additional investor interest. Second, stock buybacks are also a powerful psychological factor that demonstrates management’s confidence in its abilities and its future. Just make sure to pay attention to free cash flow when selecting stocks from a fundamental perspective. Remember that companies with free cash flow can grow the business, build factories, open new stores and develop new products to fuel profits and reward shareholders with dividends, stock buybacks and higher stock prices. F) Free cash flow may be the most important number you need to know about a company before you buy its stock. To those unfamiliar with the term, free cash flow may sound confusing, after all when is cash free. However, it makes sense when you understand what it is. Think about cash coming into a company from the sale of its products or services and follow it through the statement of cash flows. Some of the cash is used to buy materials and/or pay wages. Some of the cash pays the bills (utilities, phones, and so on). When the company finishes paying all the bills, what is left is called cash flow from operations. The company still has other expenses, such as new equipment or other capital expenses (for items that are required for growth, but are not directly related to daily business operations, such as new facilities and large equipment). Remaining Cash If the company is doing well, there will be cash remaining after all expenses (including taxes, and so on) are paid. This cash can be paid out as dividends, reinvested in the company, or invested in the market. The company could also choose to buy some of their shares back. Free cash flow is that money available to the company that is not used in the daily operations of the business. To find a company’s free cash flow, take cash flow from operations which is found on the statement of cash flows and subtract any capital spending. There are several ways to calculate free cash flow, but this one is straight forward and easy to determine. Why is it important to know free cash flow? Taking Cash Out of the Company Free cash flow is that cash you could take out of the company and not affect its operations. A company that has a history of generating free cash flow and is expected to continue throwing off free cash flow is worth more (meaning its stock should command a higher price), than a company that has an uncertain prospects for generating free cash flow. What is the “right” amount of free cash flow? That depends on the industry and whether the company in large and stable or young and growing. For example, a mature software company with a large customer base will probably throw off large sums of free cash flow, while a younger company may have a negative free cash flow. Having a negative free cash flow is expected for a young, growing company, but a red flag for a mature larger company. Understanding Free Cash Flow Understanding free cash flow is the first step to determining the value of a company. When you understand the value of a company, you can determine whether it is under or over-priced. Historically, we understand that the value of a stock is equal to the present value of its future cash flows. Thus, it is important to understand free cash flow as a basis for taking the next step in determining a value for the company’ stock.

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