Calculating FCF question

Which equation do you guys use and why?

FCF = net income + amort/deprec - changes in working cap - cap ex

or

FCF = cash from operating - cap ex

I know the two are theoretically equivalent. The internet has led me to believe that the first is old school, and the second is more accurate. I was instructed to use both methods. The second one seems like a clear winner, though, since it's a lot quicker to do, and more "accurate."

 

Two forms of FCF - levered and unlevered

Unlevered FCF = EBIT(1-T) + D/A - Change in Net Working Capital - CapEx Levered FCF = Same as above except use EBT instead of EBIT

Levered FCF is only available to equity holders since interest has already been paid off, while unlevered is available to both debt and equity holders. If plugging into a DCF you'll want to discount appropriately (i.e. WACC for unlevered, cost of equity for levered)

 
packmate:

For these types of questions its way easier to just get to EBIT and then follow the standard formula. Ex. EBITDA - D&A -> EBIT (1-t) + D&A - change in NWC - Capex.

Does it make more sense to you to do it your method? It just seems intentionally confusing

My gripe is not about which way is better. It's about how the person on the other side of the table is asking you a question that he himself doesn't have a firm grasp on. Method #3 is a perfectly acceptable way - you bypass having to subtract and re-add D&A.

 

Few people have memorized the approach from net income and EBITDA the way you described, so it's not a surprise there'd be a bit of confusion. But anyone competent should be able to work out quickly that the answer is in fact correct. If they are unwilling or unable to spend a moment doing that, then take it as a sign that it's not a good place to end up anyway, so not much of a loss. I had a few interviews where the interviewer wasn't too bright, and didn't understand what I was (correctly) saying, but again, that's a sign that you don't want to work there.

 

"that's a sign that you don't want to work there" is prob one of the most annoying things to hear and completely false in my opinion. If someone has a bad experience with ONE person at a firm that should not be a reason they do not want to work at that particular firm because that one person is just that, one person out of the entire firm and not indicative of what a persons experience will be at the firm.

 
Best Response

To OP: You're right, on Excel, but you have to understand that in person, people are locked in to their particular order of operations and something deviating from that is going to be hard to follow.

It would be best to anchor them to EBIAT after your first two lines. For (2), this is obvious. For (1), you can say "We add back after-tax interest to net income to get EBIAT", which makes sense. For (3), you can say "We tax EBITDA at the effective rate, then add back the depreciation tax shield to get to EBIAT. That way, we account for the tax effects of depreciation without counting it as an expense."

Technically, all three of your approaches are sound, but I really think this is a communication issue more than an intelligence one. If you've taken computer science and had someone try to explain their (completely functional) code to you, you'll get the gist of what I mean, and why anchoring to something familiar is so important. Hope this helps.

 
  • Had to write this 3 times already b/c it keeps giving me an error when trying to quote*

@Quincyboy7:

^ This. Definitely agree that anchoring to EBIAT / NOPAT should be the way to approach questions asking to calculate FCFF from various points on the income statement. And very true on the 2nd point - once people get so used to doing it one way, they end up forgetting the intuition and it becomes mechanical almost. Thanks.

 
deaglet3:

Had 6 ib interviews recently and twice I was asked how to calculate FCFF from various starting points (one from Net Income, other from EBITDA). Both times interviewers said I was wrong and it just pissed me off especially when you know it's not a stress test -- they genuinely thought I was wrong.

I want to clarify this to all potential candidates (and interviewers who read this): there is more than one way to calculate FCFF, depending on your starting point. Seems like some interviewers only know how to do this calculation when starting from EBIT and need to work backwards / forwards to get to EBIT as a starting point - see #2 below. This is unnecessary. There are other/faster ways to do it:

(1) Starting from Net Income:

Net Income
+ i (1-t)
+ D&A
- Chg in NWC
- Capex
= FCFF / Unlevered FCF

(2) Starting from EBIT:

EBIT (1-t)
+ D&A
- Chg in NWC
- Capex
= FCFF / Unlevered FCF

(3) Starting from EBITDA:

EBITDA (1-t)
+ D&A (t)
- Chg in NWC
- Capex
= FCFF / Unlevered FCF

Am honestly surprised about how these interviewers didn't know how to do it via #1 and #3, but hope this is useful for anyone who is asked this question in the future.

The interviewers told you that you were wrong because you were actually wrong (at least for method 3). Why would you add back D&A to EBITDA? EBITDA already excludes D&A...
 

EBIT*(1-t) + Depreciation - increases in net working cap (or + decreases in working cap) - capex +/- other non cash expenses

You should use a variety of multiples. EBITDA takes out accruals and expenses paid to debt holders (and therefore is a better proxy of cash available to financiers). Also, if a firm has no earnings but does generate EBITDA, its best to use the ebitda multiple.

 

If you think about it, the two methods you proposed are the same, not just in terms of results but also in terms of steps - to do 2) starting with op cf requires you to have done 1) going from ni to op cf in the first place.

What you do see in most models, however, is the NI to FCF calculation on your cfs and the EBITDA to FCF calculation in your summary outputs - as a bridge and as a check.

 

For starters FCFF / unlevered free cash flow and FCFE / levered free cash flow tend to be interchangeable.

The first set represents the free cash flow available to the entire firm (hence the exclusion of the interest expense since you need to look at it sans cap structure) and the other set represents the cash flows available to the equity holders (hence the inclusion of interest expense to account for the cash outflows to debt holders).

Unlevered Free Cash flow = EBITDA - capex - change in WC - cash taxes

Levered Free Cash flow = EBITDA - capex - change in WC - cash taxes - cash net interest expense

 
Devils Advocate:
For starters FCFF / unlevered free cash flow and FCFE / levered free cash flow tend to be interchangeable.

The first set represents the free cash flow available to the entire firm (hence the exclusion of the interest expense since you need to look at it sans cap structure) and the other set represents the cash flows available to the equity holders (hence the inclusion of interest expense to account for the cash outflows to debt holders).

Unlevered Free Cash flow = EBITDA - capex - change in WC - cash taxes

Levered Free Cash flow = EBITDA - capex - change in WC - cash taxes - cash net interest expense

Unlevered Free Cash flow = EBIT x (1- tax rate) + DA +/ changes in WC - capex (net of asset sales) +/- deferred taxes

Levered Free Cash flow = Net income - capex (net of asset sales) +/- change in WC +/- net borrowing

 

Unlevered FCF = cash flow excluding costs, sources, and effects (e.g. on taxes) of funding (i.e. taxes, interest expense, interest income, debt amortisation, debt issuance/drawdown, dividends, equity issue proceeds, share buybacks etc)

FCFF = Unlevered FCF FCFE = FCFF excluding equity payments and funding (so the above excluding dividends, equity issue proceeds, share buybacks etc)

When prepping for interviews, it may be useful to memorize formulas, but when modelling, its better to understand what it actually means as that makes it easier to decide where every number goes .. otherwise you will perpetually be referring to templates and will never learn how to make a model fit whatever situation you're modelling for.

In any case, if you can practice modelling before your summer, do so, but don't waste time trying to learn rigid definitions. FCF definitions and usage is whatever your group wants it to be. Pointless learning to model by rigidly using Unlevered FCF -> Levered FCF, only to get stomped by models in your group using Operating FCF -> FCF -> Net Cash Flow

 
nycvalue:
I would greatly appreciate any help on how to think about the following more accurately:

At b-school, I was taught to calculate FCF as follows: EBIT*(1-t) + D&A - Capex - changes in NWC. This gets you to unlevered FCF.

However, I often see investors calculating FCF as follows: EBITDA - Capex - Cash taxes - Cash interest expense.

My questions: What is the difference between these two methods? How does one calculate a firm's "cash taxes" and "cash interest expense" (actual formulas would be helpful here).

The deduction of interest expense in the 2nd method above implies a calculation of levered FCF, though there is no adjustment for changes in the debt's principal.

Thanks very much for any guidance.

I think that the formula "investors use" that you're talking about refers to more of an OCF metric, though it is, indeed, sometimes labeled FCF.

As for calculating cash taxes and cash interest expense, I don't understand what you mean by "actual formulas". They are fairly self-explanatory: cash taxes are the taxes that the company paid in cash for the period (as opposed to the income tax expense for GAAP purposes) and cash interest expense is the interest that the company paid in cash for the period (i.e. net of PIK interest, interest income, amortization of OIDs, etc.).

"For all the tribulations in our lives, for all the troubles that remain in the world, the decline of violence is an accomplishment we can savor, and an impetus to cherish the forces of civilization and enlightenment that made it possible."
 

Ok, but how do I find what the company actually paid in cash taxes. It's not always explicitly stated in the notes to the financial statements. I've read that you add the increase in the company's deferred tax liability to the income tax provision found on the income statement, but I'm hoping for more clarity on how to think about this.

 
nycvalue:
Ok, but how do I find what the company actually paid in cash taxes. It's not always explicitly stated in the notes to the financial statements. I've read that you add the increase in the company's deferred tax liability to the income tax provision found on the income statement, but I'm hoping for more clarity on how to think about this.

You can arrive at cash taxes by taking the income tax provision and subtracting the change in the DTL.

For example:

Say you had a company with $50 in operating income, with $20 of depreciation for tax purposes (MACRS schedule) and $10 for GAAP purposes (straight-line). Assume a 35% tax rate:

Tax return:

EBITDA: $50 Less D+A: ($20) EBT: $30 Taxes: ($10.5) Cash Tax Rate: $10.5 / $30 = 35%

GAAP Income Statement EBITDA: $50 Less: D+A: ($10) EBT: $40 Current Tax Expense: ($10.5) Deferred Tax Expense: ($3.5) GAAP Tax Rate: ($10.5 + $3.5) / $40 = 35% Cash Taxes: $10.5

For the period, you'd see a $3.5 increase in the Deferred Tax Liability on the B/S, which would be added back to net income on the cash flow statement.

"For all the tribulations in our lives, for all the troubles that remain in the world, the decline of violence is an accomplishment we can savor, and an impetus to cherish the forces of civilization and enlightenment that made it possible."
 

Of course, cash taxes are often listed in a supplemental disclosure in the CF statement, but not always. When it's not, how can I arrive at it? And how can I estimate it going forward? Is there a generally accepted way to model this?

Thanks

 

FCF= EBITDA - Capex - Cash Interest - Cash Tax - Change in Working Capital and this is FCFE

I suggest doing a consensus and in case nothing is disclosed (which is rare) just use the P&L figures for cash tax and for Cash interest Coupon*Average Outstanding Debt. In case you have done detailed analysis NOLS valuation will be used as cash tax

 

Although I would take issue with the exact methodology for the second formula, the difference is primarily the first is the unlevered free cash flow (ULFCF) calculation while the second approximates a levered free cash flow (LFCF) calculation. LFCF is the free cash flows after taking into account the capital structure of the firm, hence the inclusion of the after-tax interest charge.

 

Using EBIT*(1-T) is technically and theoretically correct. The reason being is that it uses the taxes as if there were no debt (think "hypothetical taxes.") The tax savings are accounted for in the discount rate (cost of debt cheaper due to tax deductible interest rate). Therefore, if you use NI as your starting point you're double counting tax savings.

 

Hopefully this will be more of a help than a hindrance, but it's often important to consider exactly who's FCF it is. For instance, there are formulas to compute either FCF for the Firm (which will service debt (interest), then government (tax), then owners (equity)). However, if you're an equity investor, the FCF to the firm is something you could care less about if its all or mostly taken by debt holders and the government. As an equity investor, you'd be inclined to look at FCF to equity, rather than to the whole firm.

FCF (firm) = EBIT(1-t) +D&A -CapEx -Change in WC

FCF (equity) = NI -(D&A-CapEX)(1-Debt/Capital) -(Change in WC)(1-Debt-Capital)

In the equity equation, you multiply by 1-debt to capital because this will leave you with the adjustment for solely equity.

Visit www.damodaran.com to learn more about these concepts. He is a renowned professor at Stern, and has a robust website with massive amounts of info on Corp. Fin, Valuation and other topics.

 

Firstly, if you can calculate the value of the firm through the fcf to the firm, then you implicitly know the value of the debt and preferred (needed to arrive at WACC or tax shield for APV). Similarly, if you can calculate the value of the equity through the fcf to the equity, then you implicitly know the value of the debt and preferred (needed to calculate the equity cost of capital). Therefore, both methods if implemented correctly are mathematically equivalent.

Secondly, I am almost certain that your free cash flow to equity calculation is wrong. Logically thinking about the equation, -(D&A-Capex) = -D&A+Capex, whereas it should be +D&A and -Capex. Similarly, it doesn't make sense to multiply (1-Debt/Capital), because the amount of D&A, capex, and working capital should not change (theoretically) with capital structure. Also, the debt and preferred claimholders are senior to equity, and it would not make sense to make adjustments on top of those already subtracted through net interest and preferred dividends. The equation in its most basic form, then, not considering the many adjustments that would have to be made to make this mathematically correct, is FCF(equity)=NI to common equity + D&A - Change in Working Capital - Capex, as was stated initially.

BullyBear:
Hopefully this will be more of a help than a hindrance, but it's often important to consider exactly who's FCF it is. For instance, there are formulas to compute either FCF for the Firm (which will service debt (interest), then government (tax), then owners (equity)). However, if you're an equity investor, the FCF to the firm is something you could care less about if its all or mostly taken by debt holders and the government. As an equity investor, you'd be inclined to look at FCF to equity, rather than to the whole firm. x FCF (firm) = EBIT(1-t) +D&A -CapEx -Change in WC x FCF (equity) = NI -(D&A-CapEX)(1-Debt/Capital) -(Change in WC)(1-Debt-Capital) x In the equity equation, you multiply by 1-debt to capital because this will leave you with the adjustment for solely equity.
x Visit www.damodaran.com to learn more about these concepts. He is a renowned professor at Stern, and has a robust website with massive amounts of info on Corp. Fin, Valuation and other topics.
 
antmavel:
hi,

I've found 2 methods to calculate the Free Cash Flow, which one should I use during an interview and what is the difference?

1) FCF = EBIT*(1-t) + Depreciation/Amortization - Capex - Net Increase in WC 2) FCF = Net Income + Depreciation/Amortization - Capex - Net Increase in WC

Is the second one what we call the Free Cash Flow to Equity or something like that since interest has already been deducted therefore this FCF should be only for the shareholders...I need this to be clarified. What should you answer when someone ask you to define the FCF during an interview? It seems the 1st one no?

one's levered and the other is unlevered

 

Use the first by default.

No one adds back stuff to net income to get FCF in practice. For a large company there's so much contamination in net income, you'd spend a year making adjustments.

But you still want to be prepared if they quiz you on the net income method.

 
antmavel:
1) FCF = EBIT*(1-t) + Depreciation/Amortization - Capex - Net Increase in WC 2) FCF = Net Income + Depreciation/Amortization - Capex - Net Increase in WC

In the FCFE formula you need to add the change in debt position, i.e. New Debt - Principal Repayments

 

FCF to equity is used in LBO modeling. Generally, we assume that all or nearly all of the cash available after paying interest expense is used to service debt.

Unlevered Net Income can be used in a DCF (in conjunction with WACC), where you're trying to value operating cash flows to arrive at an "intrinsic" enterprise value.

Note that if you're valuing a company with no outstanding debt, preferred stock or minority interest FCF to equity equals unlevered net income.

 
Nusi:
FCF to equity is used in LBO modeling. Generally, we assume that all or nearly all of the cash available after paying interest expense is used to service debt.
Interest expense is the servicing of debt. You mean that the excess cash is netted off against debt to reduce net debt. In theory, this is incorrect unless the debt is redeemed early because interest received on cash will typically be lower than the interest paid on debt, resulting in a slightly higher effective interest rate. This is one of the reasons why you see "management fees" being paid out to the PE owners.
Nusi:
Unlevered Net Income can be used in a DCF (in conjunction with WACC), where you're trying to value operating cash flows to arrive at an "intrinsic" enterprise value.

You mean unlevered cash flow. There will be differences arising from depreciation v capex and the tax treatment in the P&L v the tax return.
Nusi:
Note that if you're valuing a company with no outstanding debt, preferred stock or minority interest FCF to equity equals unlevered net income.
Only true if that company has no debt and no cash. Even if the company has no net debt, a difference will arise on interest received on cash v interest paid on debt.
 

It wasn't my intention to "punk" anyone - just to correct the inaccuracies in case anyone relies on this in an interview.

Yes, in practice it's easiest to assume that the excess cash goes to pay down debt. There's 3 things a company can do with excess cash; 1) Return it to shareholders (as ordinary or exceptional dividends or share buybacks) 2) Use it for acquisitions 3) Net it off against debt

For 1, unless the company has announced a change in the dividend policy, buyback or target debt level this cannot be anticipated.

For 2, without knowing what the company is going to buy (or what price it will have to pay), this cannot be modelled into forecasts.

Given the impracticalities of anticipating 1 or 2, the default for modelling is usually 3. The difference between received interest rate and paid interest rate is usually immaterial to the P&L unless the leverage is extremely high. Most analysts (I mean research analysts here) don't care enough to take the time to model it correctly and just apply an average effective rate to the overall net debt.

 

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