Free cash flows
Definition: [crh] Cash not required for operations or for reinvestment. Often defined as earnings before interest (often obtained from the operating income line on the income statement) less capital expenditures less the cDefinition: hange in working capital. In terms of a formula:
Free cash flows =
Sales (Revenues from operations)
- COGS (Cost of Definition: goods sold-labor, material, book depreciation)
- SG&A (Selling, general administrative costs)
EBIT (Earnings before interest and taxes or Operating Earnings)
- Taxes (CaDefinition: sh taxes)
EBIAT (Earnings before interest after taxes)
+ DEP (Book depreciation)
- CAPX (Capital expenditures)
- ChgWC (Change in workinDefinition: g capital)
C (Free cash flows)
There is an issue as to whether you want to define the FCFs to the firm as a whole (the cash flow tDefinition: o all of its security holders), or the FCFs only to the firm's equity holders. For firm valuation, you want the former; for stock valuation you want the latter.
To value the firm, calculate the stream of FCFs to the firm and discount this stream by the firm's WACC (Weighted average cost of capital). This will give you the value of a levered firm, including the tax benefits of debt financing. AlteDefinition: rnatively, you can discount the firm's FCFs by its unlevered cost of capital and add separately the present value of the tax benefiDefinition: ts.
To value the firm's equity, you can either take the above number and subtract the market value of all outstanding debt (liabilities) or you can calculate the FCFs to the firm's equity holders and discount this stream by the firm's levered equity cost of capital.
NotDefinition: ice that changes in working capital have the same effect on free cash flows as do changes in physical capital, i.e., capital expDefinition: enditures. For example, suppose you had to spend $XX to increase the capacity of your plant. This expenditure would be a reduction in free cash flow in the year it was made. Likewise, if you had toDefinition: increase the level of your cash balance, inventory or receivables by $XX to accommodate greater sales, then this too would result in a like rDefinition: eduction in free cash flows in the year the level of working capital was increased. [Definition and discussion courtesy of Professor Michael Bradley.]
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