AFMP4
Syllabus B. Advanced Investment Appraisal B4. Valuation and the use of free cash flows

B4bc. Free cash flows 9 / 11

Syllabus B4bc)

b) Forecast an organisation’s free cash flow and its free cash flow to equity (pre and post capital reinvestment).

c) Advise on the value of an organisation using its free cash flow and free cash flow to equity under alternative horizon and growth assumptions.

Cash that is not retained and reinvested in the business is called free cash flow.

It represents cash flow available:

  • to all the providers of capital of a company

  • to pay dividends or finance additional capital projects.

Uses of free cash flows

Free cash flows are used frequently in financial management:

  • as a basis for evaluating potential investment projects

  • as an indicator of company performance

  • to calculate the value of a firm and thus a potential share price

Calculating free cash flows for investment appraisal

Free cash flows can be calculated simply as:

  • Free cash flow = Revenue ­ - Costs ­- Investments

  • The free cash flows used to evaluate investment projects are therefore essentially the net relevant cash flows.

Example

Cow plc has earnings before interest and tax of $200,000 for the current year. 

Depreciation charges for the year have been $5,000 and working capital has increased by $2,000. 

The company needs to invest $20,000 to acquire non-current assets. 

Profits are subject to taxation @ 30% p.a.

  • Required:
    Calculate free cash flow.

Solution

$
EBIT 200,000
Less: Corporation tax @ 30%  (60,000)
Add back: Depreciation (non-cash amount)  5,000
Deduct: Capital expenditure  (20,000)
Working capital increases  (2,000)
Free cash flow  $123,000