Free Cash Flow for the Firm (FCFF): A Key Metric for Business Valuation

How to Calculate Free Cash Flow for the Firm (FCFF)

The formula to calculate FCFF can be expressed as:

FCFF = EBIT × (1 - Tax Rate) + Depreciation - Changes in Working Capital - Capital Expenditures

Where:

• EBIT: Earnings Before Interest and Taxes, reflecting the company’s profit before interest and taxes.
• Tax Rate: The company’s effective tax rate, used to adjust EBIT for after-tax cash flow.
• Depreciation: A non-cash expense that reduces EBIT.
• Changes in Working Capital: Adjustments for changes in the company’s short-term assets and liabilities.
• Capital Expenditures (CapEx): Expenditures on physical assets like equipment or property.

Steps to Calculate FCFF:

1. Start with EBIT: Begin with Earnings Before Interest and Taxes (EBIT).
2. Adjust for Taxes: Subtract taxes from EBIT to reflect after-tax operating income.
3. Add Depreciation: Add back depreciation as it is a non-cash expense.
4. Account for Changes in Working Capital: Adjust for changes in working capital (subtract increases and add decreases).
5. Subtract Capital Expenditures: Deduct CapEx, representing cash spent on physical assets.

Example of FCFF Calculation

Let’s consider a scenario to understand how FCFF is calculated.
Company ABC is a well-established player in the tech industry, and for the current year, it reported an EBIT ( Earnings Before Interest and Taxes ) of $50 million. The company faces a 30% tax rate. It also reported depreciation of $10 million and had an increase of $5 million in working capital, meaning more cash was tied up in operations. Additionally, the company made capital expenditures of $15 million to upgrade its equipment and expand its production.

Now, let’s calculate the Free Cash Flow to the Firm (FCFF) using the formula:

FCFE = EBIT x (1- Tax Rate) + Depreciation - Changes in working capital - Capital Expenditures

Substitute the values:
FCFF = $50 million x (1 - 0.30) + $10 million - $5 million - $15 million
FCFF = $35 million + $10 million - $5 million - $15 million
FCFF = $25 million

So, the Free Cash Flow to the Firm for Company ABC is $25 million.
This calculation reflects the cash available to all providers of capital (both equity and debt holders) after the company has paid its operating expenses, taxes, and made necessary investments in working capital and capital expenditures.

FCFF vs. FCFE: Key Differences

Aspect	FCFF (Free Cash Flow for the Firm)	FCFE (Free Cash Flow for Equity)
Focus	Cash available to both debt and equity holders	Cash available only to equity holders
Debt Consideration	Excludes debt payments	Includes debt payments
Purpose	Used for valuing companies with different capital structures	Primarily for valuing equity holders

Conclusion

Free Cash Flow for the Firm (FCFF) is a vital metric for assessing a company’s ability to generate cash from its operations and its financial health. It plays a critical role in business valuation, particularly when estimating enterprise value using the Discounted Cash Flow (DCF) model. For investors and analysts, understanding FCFF is crucial for making informed financial decisions and evaluating long-term potential.