Calculating Free Cash Flow to Equity
We studied the different methods to calculate the free cash flow to the firm (FCFF) in the previous articles. In this article, we will learn about how to derive free cash flow to equity (FCFE). Here too there are multiple methods involved.
However, since we already have a background in calculating cash flows, we need not go into that much detail here.
The calculation of free cash flow to equity is closely linked to the free cash flow to the firm calculation. There are slight differences which need to be highlighted in this article. To understand these differences we need to understand the concept of net borrowing.
Firms could be borrowing money and paying off debt at the same time. This could be because they are refinancing the debt at a cheaper interest rate.
Alternatively, a firm could simply be rolling over its debt to maintain a target debt amount.
Hence there are inflows and outflows that occur as a result of this simultaneously. The firms cash position will therefore experience simultaneous inflows and outflows.
We need to consider only the net effect of these flows. This can be calculated in the following manner.
This formula is of utmost important while calculating free cash flow to equity (FCFE) and will be used in each of the three cases possible.
Lets have a look at the details:
Case #1: Deriving Free Cash Flow to Equity (FCFE) From Cash Flow to Operations (CFO)
We understood that the difference between free cash flow to the firm and the cash flow from operations was simply the investment in fixed assets. We do not consider investment in fixed assets to be a part of the cash flow from operations. However, we do consider it while calculating free cash flow to the firm. Hence we arrived at the formula:
FCFF = CFO FC Investments
In case of free cash flow to equity (FCFE) we need to add one additional step. We need to account for borrowings as well. Now, we are only concerned with the cash that will be available for equity shareholders. Hence if we borrow more, more cash becomes available. If we pay off some debt, we are left with less cash. Notice we are talking about repayment of debt principal. The interest payments have already been accounted for.
Therefore, we need to consider the net effect of the borrowing as well to arrive at free cash flow to equity. The formula for the same is:
Case #2: Deriving Free Cash Flow to Equity (FCFE) From Net Income
Once again, lets understand the free cash flow to equity (FCFE) formula in contrast to the free cash flow to firm (FCFF) formula. The formula for deriving free cash flow to firm (FCFF) from net income was:
FCFF = Net Income + Non cash Expenses + After Tax Interest FC inv WC Inv
Now, with regards to the after tax interest expenses, we do not need to add them back. As far as the cash flow to equity shareholders is concerned, interest expenses are included in the outflow and hence do not need to be added back.
Also, once again we need to add back the net borrowing figure since it affects that cash that is available to the equity shareholders. The modified formula therefore is
Case #3: Deriving Free Cash Flow to Equity (FCFE) From Free Cash Flow to the Firm
Lastly, we have the simplest case of calculating free cash flow to equity (FCFE) if we are given free cash flow to the firm (FCFF) as input. Remember that the difference between free cash flow to equity (FCFE) and free cash flow to firm (FCFF) is only the debt part. Hence, we need to make 2 adjustments.
- The first adjustment will account for the interest part i.e. it will subtract post tax interest expense from free cash flow to firm (FCFF)
- The second adjustment will account for the principal part i.e. it will add the net borrowing to the calculation
Thus, to derive free cash flow to equity (FCFE) from free cash flow to firm (FCFF), the formula is:
It is therefore possible to calculate free cash flow to equity from various types of inputs.
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