### 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 |