B.2.2 Free Cash Flow Models
In the realm of financial analysis and investment, understanding the concept of free cash flow (FCF) is crucial for assessing a company’s financial health and its potential as an investment opportunity. Free cash flow models, particularly Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE), provide a comprehensive approach to valuing companies, especially those that do not pay dividends or have fluctuating dividend policies. This section delves into the definitions, calculations, and applications of FCFF and FCFE, equipping you with the knowledge to make informed investment decisions.
Understanding Free Cash Flow
Free Cash Flow (FCF) represents the cash generated by a company after accounting for capital expenditures necessary to maintain or expand its asset base. It is a critical measure of a company’s ability to generate cash and is often used by investors to assess the company’s financial performance and potential for growth.
Free Cash Flow to Firm (FCFF)
FCFF is the cash flow available to all investors, including both debt and equity holders. It reflects the company’s ability to generate cash from its operations, which can be used to pay interest, dividends, or reinvest in the business. The formula for calculating FCFF is as follows:
$$
FCFF = EBIT \times (1  \text{Tax Rate}) + \text{Depreciation}  \text{Capital Expenditures}  \text{Increase in Net Working Capital}
$$
Components of FCFF:
 EBIT (Earnings Before Interest and Taxes): Represents the company’s operating income before accounting for interest and taxes.
 Tax Rate: The corporate tax rate applicable to the company.
 Depreciation: A noncash expense that reflects the wear and tear of the company’s assets.
 Capital Expenditures (CapEx): Investments made by the company to acquire or upgrade physical assets such as property, industrial buildings, or equipment.
 Increase in Net Working Capital (NWC): The change in current assets minus current liabilities, indicating the additional capital required to support operations.
Free Cash Flow to Equity (FCFE)
FCFE is the cash flow available to equity holders after accounting for all expenses, reinvestments, and debt repayments. It represents the cash that can be distributed to shareholders in the form of dividends or stock buybacks. The formula for calculating FCFE is:
$$
FCFE = FCFF  \text{Interest} \times (1  \text{Tax Rate}) + \text{Net Borrowing}
$$
Components of FCFE:
 Interest: The cost of debt financing, which is taxdeductible.
 Net Borrowing: The net amount of new debt raised minus debt repayments during the period.
Calculating FCFF and FCFE
To effectively calculate FCFF and FCFE, follow these steps:

Gather Financial Data:
 Obtain the company’s income statement and balance sheet.
 Identify key figures such as EBIT, depreciation, capital expenditures, and changes in net working capital.

Adjust for NonCash Expenses:
 Add back noncash expenses like depreciation to EBIT, as they do not involve actual cash outflows.

Account for Changes in Working Capital:
 Calculate the increase in net working capital by subtracting the previous period’s NWC from the current period’s NWC.

Calculate FCFF:
 Use the FCFF formula to determine the cash flow available to all investors.

Calculate FCFE:
 Adjust FCFF for interest expenses and net borrowing to find the cash flow available to equity holders.
Example Calculation:
Consider a company with the following financial data:
 EBIT: $500,000
 Tax Rate: 30%
 Depreciation: $50,000
 Capital Expenditures: $100,000
 Increase in NWC: $20,000
Calculate FCFF:
$$
FCFF = \$500,000 \times (1  0.30) + \$50,000  \$100,000  \$20,000 = \$280,000
$$
Assuming interest expenses of $30,000 and net borrowing of $10,000, calculate FCFE:
$$
FCFE = \$280,000  \$30,000 \times (1  0.30) + \$10,000 = \$261,000
$$
Discounted Cash Flow (DCF) Valuation Using Free Cash Flows
DCF valuation is a method used to estimate the value of an investment based on its expected future cash flows. When applying DCF to free cash flows, the process involves forecasting future FCFF or FCFE and discounting them back to their present value.
Steps in DCF Valuation:

Forecast Future Free Cash Flows:
 Project the company’s FCFF or FCFE over a specific period, typically 5 to 10 years.
 Consider factors such as revenue growth, operating margins, and capital expenditure requirements.

Determine the Discount Rate:
 For FCFF, use the Weighted Average Cost of Capital (WACC) as the discount rate, reflecting the average rate of return required by all investors.
 For FCFE, use the cost of equity, representing the return required by equity investors.

Calculate the Present Value:
 Discount the forecasted free cash flows to their present value using the chosen discount rate.

Estimate Terminal Value:
 Calculate the terminal value, representing the value of the company beyond the forecast period, using a perpetuity growth model or exit multiple approach.

Sum the Present Values:
 Add the present values of the forecasted cash flows and the terminal value to determine the total enterprise value (for FCFF) or equity value (for FCFE).
When to Use Free Cash Flow Models
Free cash flow models are particularly useful in the following scenarios:
 NonDividend Paying Companies: For companies that do not pay dividends, free cash flow models provide a more accurate reflection of their financial performance and value.
 Significant Capital Expenditures: Companies with substantial capital expenditure requirements benefit from free cash flow models, as they account for the cash needed to maintain and grow the business.
 Changing Dividend Policies: When a company’s dividend policy is inconsistent or expected to change, free cash flow models offer a stable basis for valuation.
Interpreting Valuation Results
The results of a free cash flow valuation provide insights into a company’s financial health and investment potential. A positive free cash flow indicates that the company generates more cash than it needs to fund its operations and investments, which can be used to pay dividends, reduce debt, or reinvest in the business. Conversely, a negative free cash flow suggests that the company may need to raise additional capital to fund its operations.
Summary
Free cash flow models, including FCFF and FCFE, offer a comprehensive approach to valuing companies, particularly those with significant capital expenditures or fluctuating dividend policies. By understanding and applying these models, investors can gain valuable insights into a company’s ability to generate cash and its potential as an investment opportunity. Whether used in conjunction with other valuation methods or as a standalone analysis, free cash flow models are an essential tool in the investor’s toolkit.
Quiz Time!
📚✨ Quiz Time! ✨📚
### What does FCFF represent?
 [x] Cash flow available to all investors, including debt and equity holders.
 [ ] Cash flow available only to equity holders.
 [ ] Cash flow after dividends are paid.
 [ ] Cash flow before accounting for capital expenditures.
> **Explanation:** FCFF represents the cash flow available to all investors, including both debt and equity holders, after accounting for operating expenses and capital expenditures.
### How is FCFE calculated?
 [x] FCFE = FCFF  Interest × (1  Tax Rate) + Net Borrowing
 [ ] FCFE = FCFF + Interest × (1  Tax Rate)  Net Borrowing
 [ ] FCFE = EBIT × (1  Tax Rate) + Depreciation  Capital Expenditures
 [ ] FCFE = Net Income + Depreciation  Capital Expenditures
> **Explanation:** FCFE is calculated by adjusting FCFF for interest expenses and net borrowing, reflecting the cash flow available to equity holders.
### What is the primary use of free cash flow models?
 [x] Valuing companies that do not pay dividends.
 [ ] Calculating dividend payout ratios.
 [ ] Estimating future stock prices.
 [ ] Determining tax liabilities.
> **Explanation:** Free cash flow models are primarily used for valuing companies that do not pay dividends, providing a more accurate reflection of their financial performance.
### Which discount rate is used for FCFF in DCF valuation?
 [x] Weighted Average Cost of Capital (WACC)
 [ ] Cost of Equity
 [ ] RiskFree Rate
 [ ] Dividend Yield
> **Explanation:** The Weighted Average Cost of Capital (WACC) is used as the discount rate for FCFF in DCF valuation, reflecting the average rate of return required by all investors.
### What does a positive free cash flow indicate?
 [x] The company generates more cash than needed for operations and investments.
 [ ] The company is in financial distress.
 [ ] The company has a high dividend payout ratio.
 [ ] The company needs to raise additional capital.
> **Explanation:** A positive free cash flow indicates that the company generates more cash than needed to fund its operations and investments, which can be used for dividends, debt reduction, or reinvestment.
### Which component is not part of the FCFF calculation?
 [ ] EBIT
 [ ] Depreciation
 [x] Dividends
 [ ] Capital Expenditures
> **Explanation:** Dividends are not part of the FCFF calculation, as FCFF focuses on cash flow available to all investors before any distributions.
### When is FCFE preferred over FCFF?
 [x] When evaluating cash flow available to equity holders.
 [ ] When assessing overall company performance.
 [ ] When calculating tax liabilities.
 [ ] When estimating future capital expenditures.
> **Explanation:** FCFE is preferred when evaluating the cash flow available specifically to equity holders, after accounting for debt servicing.
### What is the terminal value in DCF valuation?
 [x] The estimated value of a company beyond the forecast period.
 [ ] The initial investment cost.
 [ ] The present value of future dividends.
 [ ] The book value of assets.
> **Explanation:** The terminal value in DCF valuation represents the estimated value of a company beyond the forecast period, often calculated using a perpetuity growth model or exit multiple approach.
### Which factor is considered in FCFE but not in FCFF?
 [x] Net Borrowing
 [ ] Depreciation
 [ ] Capital Expenditures
 [ ] Tax Rate
> **Explanation:** Net Borrowing is considered in FCFE to adjust for changes in debt, reflecting the cash flow available to equity holders.
### True or False: Free cash flow models are only applicable to large companies.
 [ ] True
 [x] False
> **Explanation:** False. Free cash flow models are applicable to companies of all sizes, as they provide insights into a company's ability to generate cash and its potential as an investment opportunity.