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FREE CASH FLOW - Cash flows without any adjustment may be misleading because they do not reflect
Business Finance (UTSGEED10053)
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F REE CAS H FLOW
Cash flows without any adjustment may be misleading because they do not reflect the cash outflows that are necessary for the future existence of a company. An alternative measure, free cash flow, was developed by Michael Jensen in his theoretical analysis of agency costs and corporate takeovers. 4 In theory, free cash flow is the cash flow left over after the company funds all positive net present value projects. Positive net present value projects are those capital investment projects for which the present value of expected future cash flows exceeds the present value of project outlays, all discounted at the cost of capital. 5 In other words, free cash flow
4Michael C. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers,” American Economic Review 76 (1985): 323–329. 5The cost of capital is the cost to the company of funds from creditors and share- holders. The cost of capital is basically a hurdle: If a project returns more than its cost of capital, it is a profitable project spent on low-return exploration and
Cash Flow Analysis 1
is the cash flow of the company, less capital expenditures necessary to stay in business (i., replacing facilities as necessary) and grow at the expected rate (which requires increases in working capital). The theory of free cash flow was developed by Jensen to explain behav- iors of companies that could not be explained by existing economic theories. Jensen observed that companies that generate free cash flow should disgorge that cash rather than invest the funds in less profitable investments. There are many ways in which companies can disgorge this excess cash flow, in- cluding the payment of cash dividends, the repurchase of stock, and debt issuance in exchange for stock. The debt-for-stock exchange, for example, increases the company’s leverage and future debt obligations, obligating the future use of excess cash flow. If a company does not disgorge this free cash flow, there is the possibility that another company—a company whose cash flows are less than its profitable investment opportunities or a company that is willing to purchase and lever-up the company—will attempt to acquire the free-cash-flow-laden company. As a case in point, Jensen observed that the oil industry illustrates the case of wasting resources: The free cash flows generated in the 1980s were spent on low-return exploration and development, and on poor diversifica- tion attempts through acquisitions. He argues that these companies would have been better off paying these excess cash flows to shareholders through share repurchases or exchanges with debt. By itself, the fact that a company generates free cash flow is neither good nor bad. What the company does with this free cash flow is what is impor- tant. And this is where it is important to measure the free cash flow as that cash flow in excess of profitable investment opportunities. Consider
These two companies have identical cash flows and the same total capital expenditures. However, the Winner Company spends only on projects that add value (in terms of positive net present value projects), whereas the Loser Company spends on both profitable projects and wasteful projects. The Winner Company has a lower free cash flow than the Loser Company, indicating that they are using the generated cash flows in a more profitable manner. The lesson is that the existence of a high level of free cash flow is not necessarily good—it may simply suggest that the company is either a very good takeover target or the company has the potential for investing in unprofitable investments. Positive free cash flow may be good or bad news; likewise, negative free cash flow may be good or bad news:
Free Cash Flow Good News Bad News
Generating substantial operating cash flows, beyond those necessary for profitable projects.
Has more profitable projects than it has operating cash flows and must rely on external financing to fund these projects.
Generating more cash flows than it needs for profitable projects and may waste these cash flows on unprofitable projects. Unable to generate sufficient operating cash flows to satisfy its investment needs for future growth.
Therefore, once the free cash flow is calculated, other
−
information (e., trends in profitability) must be considered to evaluate the operating perfor- mance and financial condition of the company.
C alcula ti ng Free Cash Flow
There is some confusion when this theoretical concept is applied to actual companies. The primary difficulty is that the amount of capital expenditures necessary to maintain the business at its current rate of growth is generally not known; companies do not report this item and may not even be able to determine how much of a period’s capital expenditures are attributed to maintenance and how much are attributed to expansion. One approach is to estimate free cash flow by assuming that all capital expenditures are necessary for the maintenance of the current growth of the company. Though there is little justification in using all
flow from op- erations for the after-tax interest, adding this amount back to arrive at an adjusted cash flow from operations. We make this adjustment because we want to estimate how much free cash flow is available to both bondholders and equity owners: 6
Free cash flow Cash flow
Adjust ed
Capital
(Definition 2) = from operations − interest − expenditures (12)
6This definition is similar to still another definition of free
cash flow, net free cash flow, which adjusts for both interest expenses, but only deducts cash taxes, not the sum of deferred taxes and cash taxes as represented by the tax expense on a company’s income statement.
We often refer to this calculation of free cash flow as the free cash flow to the firm (FCFF) because it is the flow available to the suppliers of capital. Exemplar’s interest expense is $17 million and its tax rate is 40%. Making an adjustment for the after-tax interest and financing expenses, $17 million (1 – 0) $10 million (which we round to $10 mil- lion for simplicity in our example), we have another measure of free cash flow:
Cash flow from operations $ PLUS Adjusted interest 10 Adjusted cash flow from operations
$
LESS Capital expenditures 100 EQUA LS
Free cash flow, FCFF (Definition 2)
$
Still another free cash flow is a cash flow that adjusts for the net bor- rowings of the company. The basic idea is that if we want to focus on the funds available to the owners, we need to consider not only the capital expenditures, which reduce cash flow available to owners, but also funds raised through borrowing, which are available to owners.
Free cash flow
Cash flow
Capit al
Debt
=
FREE CASH FLOW - Cash flows without any adjustment may be misleading because they do not reflect
Course: Business Finance (UTSGEED10053)
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