Measuring FCFF and FCFE

 What is FCFF?
o FCFF is the net amount of CFs to a company’s suppliers of capital including
holders of common stock, bonds and preferred stocks and left after all cash-
based operating expenses, operating investments in FC and WC
 Operating expenses include salaries, corporate overhead costs, and
taxes, to support the day to day running of the business
 Operating investments in FC are capital expenditure on PPE and
acquisitions
 Operating investments in WC only includes current assets net of
current liabilities that meant to support sales (i.e. A/R, Inventory,
A/P, accrued taxes and expenses etc. are included)
o FCFF (Net Income)
o 𝐹𝐶𝐹𝐹𝑁𝐼 = 𝑁𝐼 + (𝑛𝑒𝑡 𝑛𝑜𝑛 𝑐𝑎𝑠ℎ 𝑐ℎ𝑎𝑟𝑔𝑒𝑠 + 𝑎𝑓𝑡𝑒𝑟 −
𝑡𝑎𝑥 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 + 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑) − (𝑖𝑛𝑣. 𝑖𝑛 𝐹𝐶 + 𝑖𝑛𝑣 𝑖𝑛 𝑊𝐶)
 Net income is also an accrual measure and may contain additional
operating income that is yet to be realised (non-cash addition) and
operating expenses that do not involve any cash outflow (non-cash
deduction) during the same period
 Examples include depreciation (deduction) and amortisation
(deduction) expense, gains (addition) and losses (deduction)
from disposal of operating assets and asset impairments
(deduction), share based payments (settled using equity) etc.
 If there was an increase in depreciation ceterus paribus, we
would only add the resulting after tax component to FCFF and
FCFE (Note: the value we find in the income statement an
after-tax adjusted figure since we
 Net income is net of operating and financial expenses, taxes and
preferred dividends
 FCFF is net of taxes and so we should add back after-tax interest
expense since it is tax deductible – consistent with the WACC which is
determined on an after-tax basis which is used to discount FCFF
valuation
 The removal of net inv. in FC and WC is needed since the cash flows
relating to these items are capitalised on the b/s whilst NI is on the
bottom line of the income statement
 This is found in CFs from operating activities and investing
activities
o FCFF (CFOA)
 𝐹𝐶𝐹𝐹𝐶𝐹𝑂𝐴 = 𝐶𝐹𝑂𝐴 + 𝑎𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 − 𝑖𝑛𝑣. 𝑖𝑛 𝐹𝐶
 CFOA are derived from revenue producing activities of the
entity that help determine its profit/loss
o Examples: Receipts from customers, interest
received/earned and payments to suppliers, income
tax paid and borrowing costs
 CFOA accounts for inflows and outflows of cash (namely, cash
on hand & demand deposits) and cash equivalents (short-term
 highly liquid investments), and does not net out preferred
dividends
o 𝐶𝐹𝑂𝐴 = 𝑁𝐼 + 𝑁𝐶𝐶 + 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 −
𝑖𝑛𝑣. 𝑖𝑛 𝑊𝐶
 Payment of interest must be classified as part of operating
activities to be added back
 CFOA does not include cash flows that arise from the
acquisition and disposal of long-term assets
 Sometimes may need to adjust CFOA to remove items that are
not included in operating WC (e.g. tax assets, retirement
benefits/liabilities)
o FCFF (EBIT)
 𝑁𝐼 = 𝐸𝐵𝐼𝑇(1 − 𝑡) − 𝑎𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 −
𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
 𝐹𝐶𝐹𝐹𝐸𝐵𝐼𝑇 = 𝐸𝐵𝐼𝑇(1 − 𝑡) + 𝑁𝐶𝐶 − (𝑖𝑛𝑣. 𝑖𝑛 𝐹𝐶 + 𝑖𝑛𝑣. 𝑖𝑛 𝑊𝐶)
o FCFF (USES)
 A more intuitive measure that looks at the possible sources of CFs and
the CF requirements needed to meet the company’s operations and
comparing it to FCFF(NI, CFOA and EBIT) to see whether the amounts
computed are justified
 i.e. FCFF(NI, CFOA and EBIT) = Uses of FCFF
 Possible uses of FCFF
 ∆ in CCE balance -> FCFF may be kept in CCE to improve
financial flexibility or CCE may be drawn down to cover
negative FCFF
 After-tax interest expense & net repayments on debt -> FCFF
may be used to repay principal in excess of new borrowing or
new borrowings in excess of interest and principal repayments
may occur to cover negative FCFF
 A company may use some FCFF to pay dividend to, and
buyback shares from the common shareholders in excess of
the number of new shares issued. Alternatively, if share
issuance exceeds dividend issue and buybacks this could be to
cover a negative FCFF
 A company is obligated to pay preferred dividend to the
holders of preferred stocks
 What is FCFE?
o FCFE is the net amount of CFS available to common equity holders and left
after all cash-based operating expenses, operating investments in FC and WC
and financial transactions with debtholders and preferred stockholders have
been made
o 𝐹𝐶𝐹𝐸 = 𝐹𝐶𝐹𝐹 − (𝑎𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 +
𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑) − (𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 − 𝑛𝑒𝑤 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔)
o FCFE does not include after-tax cash flows available to the debtholders and
preferred stockholders and is computed after any financial transactions with
the two types of stakeholders
  𝐹𝐶𝐹𝐸𝑁𝐼 = 𝑁𝐼 + 𝑁𝐶𝐶 − (𝑖𝑛𝑣. 𝑖𝑛 𝐹𝐶 + 𝑖𝑛𝑣. 𝑖𝑛 𝑊𝐶) −
(𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 − 𝑛𝑒𝑤 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔)
 𝐹𝐶𝐹𝐸𝐶𝐹𝑂𝐴 = 𝐶𝐹𝑂𝐴 − 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 − 𝑖𝑛𝑣. 𝑖𝑛 𝐹𝐶 −
(𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 − 𝑛𝑒𝑤 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔)
 𝐹𝐶𝐹𝐸𝐸𝐵𝐼𝑇 = 𝐸𝐵𝐼𝑇(1 − 𝑡) + 𝑁𝐶𝐶 − (𝑎𝑓𝑡𝑒𝑟 −
𝑡𝑎𝑥 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 + 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑) − (𝑖𝑛𝑣. 𝑖𝑛 𝐹𝐶 +
𝑖𝑛𝑣. 𝑖𝑛 𝑊𝐶) − (𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 − 𝑛𝑒𝑤 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔)
 FCFE (USES)
 FCFE(NI, CFOA and EBIT) = Uses of FCFE -> assures that the
company is capable of distributing the amount of FCFE to
common shareholders or that common shareholders can cover
the shortfall in FCFE
o Possible uses of FCFE
 ∆ in CCE balance -> FCFE may be kept in CCE to
improve financial flexibility or CCE may be
drawn down to cover negative FCFE
 Cash dividend & (Share Buyback – Share
Issuance) -> A company may use some FCFE to
pay dividend to, and buyback shares from the
common shareholders in excess of the number
of new shares issued. Alternatively, they may
issue new shares in excess of dividend and
share buybacks to cover negative FCFE
o FCFE (NI, CFOA & EBIT) should equal the uses provided that the data
produced by the company is of high quality. Lack of disclosure results in a
mismatch