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What is Free Cash Flows?

Definition of Free Cash Flows

Cash not required for operations or for reinvestment. Often defined as earnings before interest (often obtained from the operating income line on the income statement) less capital expenditures less the change in working capital. In terms of a formula: Free cash flows =Sales (Revenues from operations)- COGS (Cost of goods sold-labor, material, book depreciation)- SG&A (Selling, general administrative costs)EBIT (Earnings before interest and taxes or Operating Earnings)- Taxes (Cash taxes)EBIAT (Earnings before interest after taxes)+ DEP (Book depreciation)- CAPX (Capital expenditures)- ChgWC (Change in working capital)C (Free cash flows) There is an issue as to whether you want to define the FCFs to the firm as a whole (the cashflow to all of its security holders), or the FCFs only to the firm's equity holders. For firm valuation, you want the former; for stock valuation you want thelatter.To value the firm, calculate the stream of FCFs to the firm and discount this streamby the firm's WACC (Weighted average cost of capital). This will give you the valueof a levered firm, including the tax benefits of debt financing. Alternatively, youcan discount the firm's FCFs by its unlevered cost of capital and add separately thepresent value of the tax benefits.To value the firm's equity, you can either take the above number and subtract themarket value of all outstanding debt (liabilities) or you cancalculate the FCFs to the firm's equity holders and discount this stream by thefirm's levered equity cost of capital.Notice that changes in working capital have the same effect on free cash flows as do changesin physical capital, i.e., capital expenditures. For example, suppose you hadto spend $XX to increase the capacity of your plant. This expenditure would bea reduction in free cash flow in the year it was made. Likewise, if you had toincrease the level of your cash balance, inventory or receivables by $XX toaccommodate greater sales, then this too would result in a like reduction infree cash flows in the year the level of working capital was increased.[Definition and discussion courtesy of Professor Michael Bradley.]
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