Indicate the effect on this period\'s Free Cash Flow to the Firm (FCFF) and Free

Question

Indicate the effect on this period's Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE) of a change in each of the items listed here. Assume a $100 increase in each case and a 40 percent tax rate

4. Indicate the effect on this period's Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE) of a change in each of the items listed here. Assume a $100 increase in each case and a 40 percent tax rate. FCFF FCFE Net income Cash operating expenses Depreciation Interest expense EBIT Accounts receivable Accounts payable Property, plant, and equipment Notes payable Cash dividends paid Proceeds from issuing new common shares Common shares repurchased

Explanation / Answer

Free Cash Flow to Firm (FCFF)

FCFF is the cash flow generated by the firm before debt payment but after reinvestment needs and taxes. FCFF helps in estimating the value of the entire firm, by discounting the projected FCFF by the weighted average cost of capital (WACC).

FCFF is the cash flow available to the suppliers of capital after all operating expenses (including taxes) are paid and working and fixed capital investments are made. It is calculated by making the following adjustments to EBIT.

FCFF = EBIT – Taxes + Depreciation (non-cash costs) – Capital spending – Increase in net working capital – Change in other assets + Terminal value

Free Cash Flow to Equity (FCFE)

FCFE is the cash flow after taxes, reinvestment needs, and debt cash flows. Using FCFE, one can directly calculate the value of equity by discounting the projected FCFE by the cost of equity. It is the cash flow available after all operating expenses, interest, and principle repayments have been made and necessary investments in working capital and fixed capital have been made. It can be calculated as follows:

FCFE = EBIT – interest – taxes + depreciation (non-cash costs) – capital expenditures – increase in net working capital – principal debt repayments + new debt issues + terminal value

Note that if we already have FCFF, we can use the value of FCFF to calculate FCFE as follows:

FCFE = FCFF – Interest expense * (1 – tax) + Increase in debt

Free Cash Flow to Firm (FCFF)

FCFF is the cash flow generated by the firm before debt payment but after reinvestment needs and taxes. FCFF helps in estimating the value of the entire firm, by discounting the projected FCFF by the weighted average cost of capital (WACC).

FCFF is the cash flow available to the suppliers of capital after all operating expenses (including taxes) are paid and working and fixed capital investments are made. It is calculated by making the following adjustments to EBIT.

FCFF = EBIT – Taxes + Depreciation (non-cash costs) – Capital spending – Increase in net working capital – Change in other assets + Terminal value

Free Cash Flow to Equity (FCFE)

FCFE is the cash flow after taxes, reinvestment needs, and debt cash flows. Using FCFE, one can directly calculate the value of equity by discounting the projected FCFE by the cost of equity. It is the cash flow available after all operating expenses, interest, and principle repayments have been made and necessary investments in working capital and fixed capital have been made. It can be calculated as follows:

FCFE = EBIT – interest – taxes + depreciation (non-cash costs) – capital expenditures – increase in net working capital – principal debt repayments + new debt issues + terminal value

Note that if we already have FCFF, we can use the value of FCFF to calculate FCFE as follows:

FCFE = FCFF – Interest expense * (1 – tax) + Increase in debt

FCFF FCFE Net Income 100 100 Cash Operating Exp -60 -60 Depn -10 -10 Int Exp -5 EBIT 170 175 Tax at 40% 68 70 PAT 102 105 A/R -5 -5 A/P 2 2 Property, Plant etc -15 -15 Notes Payable 0 12 Cash Dividend Paid -15 -15 Proceeds from Issuing new common shares 120 120 Common Shares repurchased -35 -35 154 169

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