Free Cash Flow

What is free cash flow?

It is the annual amount of cash that a firm has available for all of its investors after covering all expenses including new investment.

How can I calculate free cash flow?

FCF = EBIT*(1-tax rate) + Depreciation – New Investment

Notes:

1.  EBIT*(1-tax rate) is the cash flow from the firm’s operations assuming no debt financing.  We have been calling it NOPLAT.  The taxes included in EBIT*(1-tax rate) are a little bit too high for firms that have debt and utilize the interest tax deduction.  We use EBIT*(1-tax rate) because we use the after-tax cost of debt in our WACC calculation.

2.  New Investment has two components:

a)  The increase in net working capital

b)  The increase in property, plant, and equipment

In class, we defined free cash flow as EBIT*(1-tax rate)+Depreciation – Capital Expenditures.  This definition fails to deduct from cash flows the expenditures required to finance increases in working capital.  While capital expenditures can be very difficult to estimate, working capital can be assumed to be a constant fraction of sales or EBIT and increases in working capital can be measured accordingly.

What do I do with free cash flow?

The above explanation makes it easy to calculate free cash flow for previous years.  You want to project free cash flow into the future and take its present value using WACC.

How do I project future free cash flows?

Maybe the easiest thing to do is estimate a growth rate for EBIT*(1-tax rate).  Most analyst would probably say this is the same as the growth rate for sales.  You could either base your estimate of future growth on past growth rates or on management estimates, or some method of your own choosing.  A catch might be in estimating the growth rate for new investment.  If Target is in a “growth phase”, it is building lots of new stores meaning capital expenditures are substantial and expected to remain that way until a sufficient number of new stores have been opened.  You need to assume some future levels for this key variable.  Probably, percentage increases in working capital are the same as percentage increases in sales.

Sales growth:  Same store sales versus overall sales growth

Target and similar firms can make their sales grow either by growing same-store sales or by increasing the number of stores or both.  Notice that growing sales by increasing the number of stores tends to be the more expensive way to grow sales because of the capital expenditures needed to construct a new store.  Suppose we have two similar firms with equal sales for this year.  They also are projected to have the same rate of growth in future sales.  However, one of these firms achieves its sales growth by building new stores while the other achieves its sales growth by growing same-store sales.  Can you see that one firm has larger cash flows than the other?