MM TAX CLUB

What is Free Cash Flow

Free cash flow represents an available income of a firm after deducting all the revenue and capital expenditure which can be used for expansion of the business in future or to pay dividend.

Purpose

Free Cash Flow calculated to evaluate actual earning of the firm and to evaluate future performance.

Need

Calculation of Free Cash Flow Mainly need for Valuation of Company where irregular dividends and in case of merger and Acquisition.

Illustration

Let’s we understand F.C.F with example:

 Suppose a firm has sales of Rs.1200/- Operating Cost (excluding depreciation)  Rs.600/-, Depreciation Rs.50/-, So we can calculate EBIT as under;

Sales                                                                      1200/-

Less: Operating Cost                                              600/-

Depreciation                                                            50/-  

EBIT                                                                      550/-

Less:Tax@40%                                                     220/-

EAT                                                                       330/- 

For the purpose of calculating free cash flow we have to identify depreciation, Because depreciation is non cash transaction, Practically there is no cash outflow of Rs.50/- but we get tax credit on the same. It means firm will have earning after tax plus Depreciation.

Since we are looking for F.C.F of the firm, hence we will not reduce interest from EBIT.

EAT                                                        330/-

Add: Depreciation                                    50/-

NOPAT                                                  380/-

 Now Rs.380/- is Net cash inflow to the firm after deducting Revenue expenditure  and Taxes, but even its not represents F.C.F to firm because the firm may require fund to Operate and maintain  business.

To operate they may need addition working capital and to maintain business they may need Capital expenditure (i.e. F.A)

Let say Capex is Rs.100/- and additional Working Capital Rs.75/-, we need to deducted these two items to get F.C.F to the firm.

NOPAT                                                 380/-

Capital Expenditure                             100/-

Change in Working Capital                   75/-

Free Cash Flow                                 205/-

Summary

F.C.F is available earning to the Equity holders and Lender of the firm which can be freely used by the firm at their discretion.