Free Cash Flow is the amount of cash flow a firm generates (net of taxes) after taking into account non-cash expenses, changes in operating assets and liabilities, and capital expenditures.
Free Cash Flow is a more accurate metric than EBITDA, EBIT, and Net Income as they leave out large capital expenditures and change in cash due to changes in operating assets and liabilities. Also, metrics such as EBIT and Net Income include non-cash expenses, further misrepresenting the true cash flow of a business.
Due to the reasons mentioned above, Free Cash Flow is often used in a DCF analysis and therefore, a clearer understanding of the concept is important for finance interviews, especially for Investment Banking and Corporate Finance roles.
Free Cash Flow to firm
FCFF = Operating EBIT – Tax + Depreciation or Amortization (non-cash expenses) – Fixed capital expenditures – Increase in net working capital
Alternatively, FCFF = Cash flow from operations (taken from cash flow statement) + Interest expense adjusted for tax – Fixed capital expenditures
FCFF = Net Income + Interest expense adjusted for tax + non-cash expenses – Fixed capital expenditures – Increase in net working capital
Thus, FCFF stands for free cash flow for the firm and it is a financial performance metric that looks at the amount of cash created by a company after all expenses, taxes, changes in net working capital, and changes in investments have been taken into account.
Free Cash Flow to equity
FCFE is a term that stands for free cash flow to equity and it indicates the amount that is distributed to equity shareholders once all expenses, changes in net working capital, debt repayments, etc. are decreased and new loans are added.
The calculation of FCFE is important since it will aid in determining the firm’s value. FCFE is often used by experts to assess the value of a firm or company, and it can be used in place of dividends for this objective. When FCFE is used in stock valuation, this is demonstrated. Instead of dividends, as in the dividends discount model, the FCFE model of stock valuation uses free cash flow to equity to value stock.
We arrive at enterprise value whenever we apply DCF using FCFF by discounting the cash flows with the weighted average cost of capital (i.e., WACC). Because FCFF considers the complete capital structure of the company, the costs of all sources of capital are included in the discount rate.
This cash flow, i.e., FCFE is also known as levered cash flow because it includes the impact of leverage. As a result, if the firm’s primary source of capital is common equity, its FCFF and FCFE are likely to be equal.
But when we use the FCFE model to construct a DCF, we discount the cash flows with the cost of equity to arrive at an equity value. Because FCFE is the amount left over for only equity shareholders, only the cost of equity is treated as a discount rate.
Normally, FCFE is calculated after adjusting the post-tax operating EBIT of a company in respect of non-cash costs, interest expenses, capital investments, & net debt repayments.
FCFE = Operating EBIT – Interest – Tax + Depreciation or Amortization (non-cash expenses) – Fixed capital expenditures – Increase in networking capital – Net debt repayment
Alternatively, FCFE = Cash flow from operations – Fixed capital expenditures – Net debt repayments + New debt
The company could use the residual cash to fund:
- Dividend Issuance: Payout cash dividends directly to preferred and common shareholders
- Stock Buyback: Buying back shares reduces the shares outstanding, which reduces dilution and can artificially boost the value per share
- Re-Investments: The company could reinvest the cash into its operations, which in the ideal scenario would increase the share price.
Difference between FCFF vs FCFE
The key difference between Unlevered Free Cash Flow and Levered Free Cash Flow is that Unlevered Free Cash Flow excludes the impact of interest expense and net debt issuance (repayments), whereas Levered Free Cash Flow includes the impact of interest expense and net debt issuance (repayments).