Build free cash flow from operating economics

Learning goals

• Calculate FCFF.
• Explain why 54 applies to this case.
• Identify the case-specific assumption or failure mode before taking action.

Draft · approximately 45 minutes, excluding further revision.

Shared case and decision context

A company has EBIT 100, tax 25%, depreciation 20, capital spending 30 and investment in operating working capital 10. Interest is 8 and net borrowing 5. Assume no other noncash items. WACC is 8%; equity cost is 10%.

Economic or professional mechanism

FCFF measures cash available to all capital providers after operating taxes and reinvestment, before financing distributions. Starting from EBIT avoids subtracting interest twice. FCFE subtracts after-tax interest from FCFF and adds net borrowing. Working-capital investment consumes cash even if accrual earnings rise.

Apply, challenge and communicate

FCFF is 55 and FCFE 54. Discount FCFF with an appropriately matched WACC and FCFE with equity cost. Forecast capital expenditure, depreciation and working capital consistently with sales growth; setting reinvestment to zero while retaining rapid perpetual growth is usually economically inconsistent.

Financing policy, proxies and a complete value bridge

FCFF values operating cash available to all capital providers, so use WACC and subtract debt/other senior claims to reach equity; FCFE values cash to common equity at its required return. A debt-funded repurchase can raise near-term FCFE through net borrowing while increasing future interest, leverage and equity risk. It does not create operating value merely by changing the share count. Dividends redistribute cash; unlike FCFE they can be smoothed or constrained by policy. Use a DDM when distributions reasonably represent the equity cash capacity, and FCFE when payout policy differs materially.

Net income omits reinvestment and includes noncash accruals; EBITDA omits cash tax, maintenance capex and working-capital needs. Neither is automatically distributable cash. Forecast sales, margins, tax, depreciation, capital intensity, working capital and financing consistently. A high-growth stage with changing reinvestment should transition to sustainable growth rather than preserve an exceptional margin forever.

Supplemental case: next two FCFF are 65 and 70; stable year-three FCFF is 72.1, WACC 8%, perpetual growth 3%, net debt 200 and 50 shares. Terminal enterprise value at year 2 is 72.1/(.08−.03)=1,442. Present enterprise value=65/1.08+(70+1,442)/1.08²=1,356.4815; equity=1,156.4815 and value/share 23.1296. Against price 25 this model indicates overvaluation, conditional on inputs. A sensitivity grid must alter growth, reinvestment and discount rates coherently; growth must stay below WACC in this perpetual model. A terminal multiple is an alternative estimate, not a license to combine inconsistent cash definitions.

Finance growth instead of assuming it is free

In a separate stable operating case, next-year NOPAT is 100, sustainable growth is 3% and incremental return on invested capital is 12%. If growth is funded by operating reinvestment, the stable reinvestment rate is g/ROIC=25% and next-year FCFF is 75. At WACC 8%, stable operating value is 75/(0.08−0.03)=1,500. This model assumes stable risk, returns and capital intensity and that the 100 is next year’s income; it is not the current-year cash flow grown twice.

Raising g to 4% while keeping incremental ROIC 12% requires reinvestment of one third of NOPAT. Keeping next-year NOPAT fixed at 100 for this isolated sensitivity gives FCFF 66.6667 and value 1,666.6667 at unchanged WACC 8%. If incremental ROIC instead equals WACC, extra growth has no value effect in this stable formulation because the additional reinvestment offsets it. When incremental ROIC falls below WACC, growth can destroy value. A practical forecast must also update the explicit-stage income, risk and transition assumptions coherently.

Formula and assumptions

FCFF=EBIT*(1−T)+D&A−capex−deltaNWC; FCFE=FCFF−interest*(1−T)+net borrowing

Case analysis with explicit assumptions

1. A company has EBIT 100, tax 25%, depreciation 20, capital spending 30 and investment in operating working capital 10. Interest is 8 and net borrowing 5. Assume no other noncash items. WACC is 8%; equity cost is 10%.
2. Method: FCFF=EBIT*(1−T)+D&A−capex−deltaNWC; FCFE=FCFF−interest*(1−T)+net borrowing
3. Case result: 55. FCFF is 55 and FCFE 54. Discount FCFF with an appropriately matched WACC and FCFE with equity cost. Forecast capital expenditure, depreciation and working capital consistently with sales growth; setting reinvestment to zero while retaining rapid perpetual growth is usually economically inconsistent.

Errors to catch

• Do not replace the stated assumptions with an unstated shortcut. Reconcile units, timing and the claim being valued or duty being assessed.
• The equity cost by definition is not a defensible conclusion for these case facts.

Original knowledge check

Answer every question before checking. Review explanations after submitting; retry starts a new attempt.

Sources and coverage status

These original lessons are drafts. Public outlines are used to check scope; the official learning-outcome text and proprietary question banks are not reproduced here. Follow the source for exam-year requirements and updates.

• Reference · www.cfainstitute.org
• Reference · www.investor.gov
• Reference · pages.stern.nyu.edu