Free Cash Flow to Firm

Free cash flow to equity asks what is left for shareholders after the lenders have been paid. Free cash flow to the firm asks a question one level up: what does the business produce, before anyone is paid at all?

That makes FCFF blind to the capital structure. Two companies running identical plants generate identical FCFF whether one is funded by borrowing and the other by equity — which is precisely why analysts reach for it.

The workbook gives two routes to the same number.

Direct, from the cash flow statement: operating cash flow, less capital expenditure, less the tax benefit on interest payments.

Indirect, from the P&L: EBIT × (1 − tax rate), plus depreciation and other non-cash charges, less any increase in non-cash working capital (add a decrease), less capital expenditure incurred (add proceeds from sale of assets). Amortisation of capital expenses and loss on sale of assets are added back with depreciation; gains on sale of assets are deducted.

The reason to prefer FCFF over FCFE is stated plainly: unless a company has an objective debt policy, net borrowings and repayments cannot be estimated objectively, and an arbitrary assumption there introduces significant bias. FCFF never asks the question.

Discount FCFF at WACC and you get the value of the firm. To reach the shareholders' value, subtract minority (non-controlling) interest, preference share capital and interest-bearing debt.

FCFF (indirect) = EBIT × (1 − t)
                + Depreciation and non-cash charges
                − Increase in non-cash working capital
                − Capital expenditure

Firm value  = FCFF discounted at WACC
Equity value = Firm value − minority interest
                          − preference capital
                          − interest-bearing debt

A cement company: EBIT Rs 640 crore, tax 25%, depreciation Rs 210 crore, increase in non-cash working capital Rs 85 crore, capital expenditure Rs 300 crore.

FCFF = 640 × 0.75 + 210 − 85 − 300
     = 480 + 210 − 85 − 300 = Rs 305 crore

Capitalise it at a WACC of 11% with 4% perpetual growth:

Firm value = 305 × 1.04 ÷ (0.11 − 0.04) = 317.2 ÷ 0.07 = Rs 4,531 crore

Now step down to the shareholders. Interest-bearing debt Rs 1,200 crore, preference capital Rs 150 crore, minority interest Rs 90 crore:

Equity value = 4,531 − 1,200 − 150 − 90 = Rs 3,091 crore
On 15 crore shares                      = Rs 206 per share

Why this route rather than FCFE. Had the analyst valued equity directly, the model would need an assumption about net borrowings. Assume Rs 40 crore and the answer is one thing; assume Rs 100 crore and FCFE is Rs 60 crore higher, which at the same 7% capitalisation rate is Rs 891 crore of extra equity value — nearly 29% — created by an assumption about the treasury department rather than by the business. That is the bias the FCFF model sidesteps.

Chapter 10 (section 10.5) presents FCFF as the third DCF approach, after the dividend discount model and FCFE. Expect a computation by the indirect method, a question on why FCFF is preferred when a company has no stated debt policy, and the pairing with WACC as the discount rate.

• FCFF goes with WACC; FCFE goes with cost of equity. Discounting FCFF at the cost of equity is the single most common error in the chapter.
• Interest is not subtracted from FCFF. It enters only through EBIT × (1 − t) in the indirect build, and through the tax benefit on interest in the direct build.
• The workbook's direct FCFF table is captioned "Free cash flow to equity" (Chapter 10.5). The line items are the FCFF build — operating cash flow, less capex, less the tax benefit on interest. Read the items, not the caption.
• An increase in non-cash working capital is subtracted; a decrease is added. The sign catches people out, and it is the same idea as core working capital absorbing cash as sales grow.
• Loss on sale of assets is added back, gain on sale is deducted. Both are non-operating and both are already inside EBIT.
• Firm value is not equity value. Minority interest, preference capital and interest-bearing debt all come out before you divide by the share count.