Levered FCF - Mandatory Debt Payments vs Net Debt
When looking for the Levered Free Cash Flow formula I find two versions:
A) Net Income + deferred taxes + depreciation & amortization + changes in net working capital - capex - mandatory debt payments
B) Net Income + deferred taxes + depreciation & amortization + changes in net working capital - capex - net debt
where net debt = new debt issuance - debt repayment
Could someone help me understand which one is considered "right / better". I feel A) would give you the theoretical maximum Levered Free Cash Flow while B) might be more of a real case application (Capany X has lower FCFE in Year Y since it decided to pay back the majority of its debt that year. This was not necessarily mandatory.)
Is my thinking correct? Is there anything else missing from the formula to be comorehensive?
Thanks!
as the levered fcf leaves the cash that is available only to equity holders, you need to somehow factor out debt holders - that is the reasoning behind why you'd need to subtract debt payments.
Formula A and formula B you just posted here are exactly equal but in one you include mandatory debt payments and in the other net debt.
Formula A. In here you assume that outflows of cash are impacted by debt repayments - which is true. Nothing to add further from my side.
Formula B. Here you have the same repayments ("debt repayment") but you include the fact that can be new debt issued. Let us think about it. Net Income already is capturing the fact that the firm can have x level of interest expenses. But new debt issuances is conditioned - usually - on the level of cash the company has available to pay. This formula would mean that you have a cash-adding variable such as new debt issuances.
For me A makes more sense. While it is true that debt is an adding factor of cash, I am highly inclined to believe that the new debt issued is not cash entirely available to shareholders - in any case to debt holders. But I might be wrong so would like to receive inputs on it.
Cheers to you
two comments:
in order to include mandatory debt repayment, do you have details on the existing cap structure and debt terms?
in terms of net debt, partly agree with what lifeboat said. but cash is fungible, and once debt interest expense and amortization/repayment (contractual obligations) are fulfilled, all excess cash should accrue to the benefit of shareholders
Formula B is wrong. Cash inflow from financing (debt issuance in your example) is not operational and recurring, therefore should not be included in any form of cash flow analyses used for valuation purposes. While formula A is the "correct" approach, the limitation of using mandatory debt repayments as a proxy for a company's debt obligations is that it only accurately reflects debt with a regular repayment/amortization schedule, i.e. credit facilities/term loans, etc.
If you have a lot of debt in your cap structure with a bullet maturity or structured repayment schedule, looking at a static FCF figure for a period may not be that helpful. This is typically why corporate/commercial bankers look at a number of different metrics (i.e. fixed charge coverage, leverage, interest coverage ratios, etc) to determine the creditworthiness of a company.
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