What is “Free Cash Flow to Firm”?

Free Cash Flow to Firm (FCFF) is an important part of the Discounted Cash Flow (DCF) model that evaluates the intrinsic value of a business. It is the cash flow that is available to providers of capital (i.e. stock and bondholders etc.) after payment of all operating expenses and investments in working capital and CAPEX has been made.

It can also be defined as the excess cash flow that would be available to a business if it was free of debt. The FCFF, a key cash flow concept, can directly be used in DCF analysis (a business valuation method) to value a business and its equity and can serve as an economically sound basis for business valuation.

Key Learning Points

  • The FCFF of a company provides an insight into its underlying cash inflows and outflows
  • Calculation of FCFF is the first step in the two-step DCF model – it can also be used to calculate the terminal value of a business
  • For the calculation of the historical and forecast period FCFF of a business, the management needs to provide both historical data and forecast information on certain variables

FCFF – Salient Points and Formula

The underlying objective of calculating the FCFF is to gain an insight into what the true cash inflows and outflows of a company are.

The FCFF of a business has to be computed first by the valuation team for both the historic year and the forecast years (typically 3-5 years) in a discounted cash flow valuation analysis – that wants to assess the cash generating ability of a business to evaluate its intrinsic value. Thereafter, in such valuation analysis, the FCFF with a terminal growth rate can also be used to calculate the terminal value of a business. This (terminal) value includes the value of all expected free cash flows of a business beyond or outside a particular forecast period.

The FCFF is calculated using the following formula:

FCFF = NOPAT + D&A – CAPEX – Changes in Net Working Capital

NOPAT (or EBIAT) = Net Operating Profit After Tax (i.e. this is EBIT – Tax i.e. Tax on EBIT)

D&A = Depreciation and Amortization (non-cash expenses)

CAPEX = Capital Expenditure

Depreciation and amortization are non-cash expenses and therefore have to be added back, while capital expenditure and changes in net working capital have to be subtracted, in order to arrive at the FCFF. Further, the tax must be deducted to arrive at FCFF (some practitioners use marginal tax rate, while others use a long-term expected effective tax rate).

The FCFF calculation starts with EBIT, which can be forecast as a margin on sales or a more detailed operating profit forecast can be constructed.

Next, the DCF terminal value can be calculated either by the perpetual growth or explicit multiple methods.

Sometimes valuation teams do not have access to detailed information on a company, particularly in the case of private companies. In such situations, an alternative FCFF formula can be used:

FCFF = Net Income + D&A + Interest Expense (1-tax rate) – CAPEX – Change in Net Working Capital

Free Cash Flow in Firm (FCFF) – Example

Assume that Company A (metals industry) has provided both historical data (Year 0) and forecast information for three years (Year 1 to Year 3) to complete a discounted cash flow (DCF) valuation analysis.

The two-step DCF analysis includes the calculation of the FCFF (historical and forecast years) and a terminal value among several other steps. Here, we focus predominantly on constructing FCFF for the historical year and forecast years (3) using part of the management forecast data. Further, the terminal value has also been calculated.

The FCFF formula has been used to calculate the FCFF for the aforesaid years. The taxation rate is 25% and EBITDA is equal to EBIT plus D&A. In a DCF model, the two major components are firstly the forecast period and secondly the terminal value. There are two methods to calculate the latter – perpetual growth and exit multiple methods.

Given below is the calculation of the terminal value using the exit multiple methods (terminal value = financial metric x multiple). The assumption is that the ‘average’ company in this industry trades at 8x EV/EBITDA multiples. We use the same multiple to calculate the Terminal Value (i.e. EBITDA * 8.0). The exit multiple methods assume that the business is sold for a multiple of a financial metric (e.g. EBITDA)  the multiple here is 8x.