I’ve had quite a few questions on the Free Cash Flow material for the level 2 CFA exam so thought I would put together a post on the topic.
Free cash flow is an extremely important measurement and you will need it extensively in the equity section of the exams as well as in your professional career.
It represents the cash available to either equity investors or all capital providers after all working capital and fixed capital needs have been reduced.
Download Mock Exams for 2019 Exam Levels I, II and III by clicking here.
Free Cash Flow to the Firm (FCFF) is the cash flow available to all capital providers (debt and equity) and equals:
Net income + Net noncash Charges (depreciation and amortization) – Investment in working capital – Investment in Fixed capital + after tax interest expense
FCFF is discounted at the weighted average cost of capital (WACC) since it is the after-tax cash flow to all suppliers of capital.
Free Cash Flow to Equity (FCFE) is the cash flow available to common shareholders and equals:
Net income + Net noncash Charges (depreciation and amortization) – Investment in working capital – Investment in Fixed +/- net borrowing
- Notice that FCFE is FCFF except without adding back interest expense and taking net borrowing into account.
- Understand how to arrive at FCFE or FCFF with CFO
- FCFF = CFO + INT (1-t) – invest fixed capital
- FCFE= CFO – invest fixed capital +/- net borrowing +/- net change in preferred shares
FCFE is discounted at the required rate of return for equity since it is the cash flow only to equity shareholders. Using the WACC for FCFE will overestimate equity value since the weighted average cost will be lower than the cost of equity.
FCFE is a more direct way to value equity, so preferred but FCFF may be preferred when the company has a volatile capital structure or is highly leveraged.
The most difficult part in FCF calculations, for me, was the adjustments to net income to arrive at FCFF. Remember: depreciation, amortization, restructuring expenses, losses on fixed asset sales, deferred tax liabilities, after-tax interest expenses and preferred stock dividends are all added back to net income. Any gains on the sale of fixed assets, the amortization of long-term bond premiums, deferred tax assets, and investments in FC and WC are all subtracted from net income.
It’s a pain but you absolutely have to understand and be able to calculate all the approaches of FCF estimation: net income, net cash flow, EBIT, EBITDA, and FCFE from FCFF. Start with the calculation from net income to get a good feel for the adjustments and what is being built into FCF, this should make the other equations more intuitive.
Not only will practicing these formulas help get you points on the exam but they also help with a better understanding of the Statement of Cash Flows and how funding works for a company.
FCF models for valuation are most appropriate when the company does not pay a dividend and/or when the investor has a controlling share or influence in the company. FCF models may not be as appropriate for fast-growing companies with high capital expenditures and negative free cash flows.
As always, try to first understand the basic concept of what FCF means and what is happening in the formulas. Understand what non-cash items and capital expenditures are on the Statement of Cash Flows and why they added or subtracted to arrive at free cash flow.
Understanding the accounting in terms of why things are adjusted instead of just numbers and symbols will go a long way to your success on the exams and as an analyst.
As with all topics, you need to understand the major difference between important concepts (i.e. FCFE versus FCFF) and when it is most appropriate to use each. Also understand the advantages, disadvantages and assumptions within the models. Understanding these conceptual ideas will get you a lot of the points even if your memory on the formulas fails you.
Less than a month to the exam, let me know if you have any questions and good luck.
‘til next time, happy studyin’
Joseph Hogue, CFA