However because capital expenditures for many

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Unformatted text preview: ents. However, because capital expenditures for many companies tend to be “lumpy” (that is, vary significantly from year to year), caution should be applied in interpreting the year-to-year variations in FCF that are due solely to the “lumpiness” of cash flows. 2 Free cash flow and agency theory Michael Jensen developed a theory of free cash flow in an agency context. 1 The theory focused on the availability of free cash flow and the agency costs associated with this availability. His theory associated agency costs with free cash flow: if a company has free cash flow, this cash flow may be wasted and, hence, is underutilized – resulting in an agency cost. There has been research and debate as to whether there are truly costs to free cash flow, yet his theory did shift focus away from earnings and towards to the concept of free cash flow. Free cash flow to equity In the valuation of the equity of a company, we need to consider that owners, as the residual claimants, are affected by the debt financing of a company. Therefore, the free cash flow to equity (FCFE) is the FCF adjusted for the debt cash flows. 2 The debt cash flow adjustment, or net borrowings, is: debt Net borrowing = new debt − financing repayment The free cash flow to equity, starting with the cash flow from operations, is: (EQ 7) (EQ 8) FCFE = cash flow capital net + from operations expenditures borrowing Another form of the calculation is to start with net income and then add non-cash charges (or subtract non-cash income), such as depreciation, amortization, charges for the write-down of assets, and deferred income taxes: (EQ 9) FCFE = Net + non-cash capital net + income charges (income) expenditures borrowing Free cash flow to the firm We can calculate the FCFF by starting with cash flows from operations: (EQ 10) FCFF = ( ) ⎡ ⎤ Cash flow capital + ⎢Interest 1- tax ⎥ from operations rate ⎦ expenditures ⎣ Another approach is to b...
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