The formula for
FCF = EBIT + Depreciation - Cap Ex - changes in Working Capital
Now my question is why isn’t Interest and Tax deducted to arrive at actual cash flow? Depreciation is a non-cash expense so thats understandable but both Interest and Tax are cash & recurring expenses so why are they excluded?
Just want to understand the logic behind this.
Not truly sure about this,i 'm under the impression that tax ,at the very least is an expense which can be reduced(through non operating losses among other things) and so can interest(restructuring,refinancing etc) …basically by trying to estimate free cashflow we are trying to estimate the intrinsic excess generating capacity of the business.
Please do keep in mind that estimating the long term Free cashflow prospects of a company is somewhat like aiming at a moving target dependent not the very least on your understanding of the industry the company operates in,new developments(especially the introduction of newer more productive capital assets like more efficient machines like in say textiles industry or the dreaded technological redundancy for eg being HP in the era of tablets and smartphones) and even changing industry dynamics especially competition (just witness the entire telecom industry today).
I’m under the impression that very few businesses can give you BOTH a precise enough idea of their fcf capacity to be subjected to a dcf calculation in ms excel AND BE INVESTING WORTHY.Often enough these will possess more than a few characteristics of a monopoly(with the exception of services businesses like IT,consultancy etc) examples that come to the mind include itc/vst(india’s most profitable tobacco co.which basically sell to addicts),software companies(microsoft and god-help-me Zylog) and even ‘geographical monopolies’(noida toll bridge…amazing write ups available both on valuepickr and mr.bakshi’s blog and generally anything that charges a rent ) and even a select few non tobacco fmcg companies.
p.s. sorry for digressing from the question you asked ,just wanted to ensure that you are able to appreciate the complexity of the beast called fcf and avoid the mistakes i made.Will report back to you if i m able to find a more precise answer.
Thanks Shravan… That was quite elaborate and no you didnt digress from the topic. Understanding something from angles is quite necessary.
After a lot of thought I understood that interest may be avoided from FCF coz the principle can be repaid from the cash generated. But Tax is an unavoidable expense. Also by excluding Tax from the FCF we are missing on a big advantage which a few previously loss making companies would have in terms of Accumulated losses.
Does this make any sense?
Additionally…tax is not deducted also because the amount can vary based on capital structure…higher the debt, lesser is the tax. so FCF is first distributed to bond holders, then govt and remaining to equity holders…
Need a quick help for a capital budgeting problem.
I have calculated project NPV by disounting all cash inflows and outlflows (including capex).
My query is: Does project NPV accrue entirely to equity owners? OR should debt be subtracted from Project NPV to arrive at NPV for equity holders?
I shall highly appreciate a quick help here.
As part of inflow if you would have taken only equity investment, then out flow is interest only. The timing should be as per due dates for interest. But leverage will increase the NPV if return is higher than the interest cost of debt.
To compare between projects with various debt/equity structure you should consider debt also as investment and interest cost can be ignored. NPV is used for comparisons, so this should be the case. Consider total capital as investment (outflow) and returns from the project as cash inflows.
Discounting will be with required rate of return.
Thanks for your reply.
I discounted FCF (EBIT-Tax- working capital - capex) to arrive at PV. From this total project cost was reduced to arrive at Project NPV.
My question is: Does this NPV entirely belong to equity investors? Or does it need to be shared with lenders as well?
If you are taking a company’s free cashflow totally then NPV is arrived at by using Weighted average cost of capital which includes cost of debt and equity. Again this is used for comparing b/w similar projects/companies. NPV is used only for studying feasibility of a project or selecting b/w projects. This not available as such to anyone.
If you want equity holder’s NPV look at free cash flow to equity (you subtract interest cost net of tax) and discount by required rate of return for equity capital.