1) Operating cash flows (OCF) 2) Capital Expenditures (CAPX) 3) Increases in Net Working Capital (∆NWC) note: increases will be + if NWC decreases then negative and will subtract a negative below, or add change in NWC FCF is : FCF = OCF – CAPX – ∆NWC Free Cash Flows.
16 1 (a) Operating cash flows (OCF) = EBIT x (1 - Tax Rate) + Depreciation. – The operating cash flows generated by just the assets (no effect of interest or tax shield from interest) – EBIT = Earnings Before Interest & Taxes = Sales – Costs - Depreciation . – Why add back depreciation? Depreciation reduced EBIT but was not a cash expense. – Only the tax savings of depreciation is a cash flow. 1 (b) Alternatively, where EBITDA = EBIT + Depreciation – OCF = EBITDA*(1-Tax Rate) + (Tax Rate)*Depreciation. – Same OCF either way you calculate it Free Cash Flows: 4 steps Value of the depreciation tax shield
17 – Example 1: Omega Inc. has sales (revenue) of $100,000; operating costs (expenses not including depreciation) of $30,000; and depreciation expense of $10,000. The tax rate is 30%. What is the OCF? – OCF = (100,000 – 30,000 – 10,000) x (1 - .3) + 10,000 = $52,000 OR – OCF = (100,000-30,000) x (1 - .3) + 10,000 x .3 = $52,000 Free Cash Flows: 4 steps EBIT (1 – t)= EBIT – EBIT * t= EBIT – tax on EBIT
18 2. Compute Capital Expenditures (CAPX) – Purchase of new equipment – e.g., lab equipment, buildings. – Positive CAPX (buying something) is a cash outflow, negative CAPX (selling something) is a cash inflow. – CAPX is either given (on the statement of cash flows) or we can infer this cash flow from firm balance sheets. • Balance sheet reflect this as Fixed Assets or Property, Plant and Equipment (PPE) • Net Fixed Assets = Gross Fixed Assets – Accumulated Depreciation • Interested in the change in Gross Fixed assets : Increase is a cash outflow; decrease is a cash inflow • Often only Net Fixed Assets (NFA) is available • CAPX = Change in NFA + Depreciation Expense – Note we add back depreciation to adjust for how depreciation is accounted for in Net PPE. Free Cash Flows: 4 steps
19 3. Compute Change in Net Working Capital (∆NWC) – Recall Net Working Capital = Current Asset – Current Liabilities – Changes in NWC affect cash flows because they need to be financed with cash. It is the change in short-term accounts. – An increase in NWC is a cash outflow (you bought something, on net), while a decrease in NWC is a cash inflow (you sold something, on net). – Only consider non-financing NWC. This means that we will ignore (excess) cash and ignore debt payments. • Note: if change in cash is stated as used for operations (not excess) we would include that. Free Cash Flows: 4 steps
20 • Example 1. When a new project is undertaken it may take a while for customers to pay new sales, i.e. accounts receivable will increase. – You recorded the sales and thus sales revenue and OCF record this as an inflow.
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