Free cash flow is the excess of operating cash flow above capital expenditures. There are two methods using free cash flow which are used for determining free cash flow. Today, we look at Free Cash Flow to Firm (FCFF)
FCFF is the discretionary cash that's available for the firm's investors and creditors (debt holders) after accounting for the necessary investments in working and fixed capital have been made. Using methods similar to the direct and indirect method, it can be determined using either net income (NI) or cash flow from operations (CFO) as a starting point. Using net income as a starting point:
FCFF = NI + non-cash charges + (Interest Expense x (1 - tax rate)) - FCInv (capital investment / expenditure) - WCInv (working capital investment / expenditure)
- Non-cash charges include items such as depreciation and amortization
- Interest Expense x (1 - tax rate) is the equivalent to tax sheltering provided by debt (related to the cost of debt).
- FCInv is NOT CFI. CFI also includes *discretionary* uses of cash which are NOT included in FCFF. What are "discretionary" uses of cash? In this context, cash inflows from investing (selling off PPE) is considered discretionary. Note that FCInv is only Cap Ex!
FCFF = CFO + (Interest Expense x (1 - tax rate)) - net capital expenditure
It is essentially the cash flow that describes how much cash is available to the firm can use to cover its obligations and therefore is a good measure of solvency.
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