A company is performing financial statement modeling for a new project. The project is expected to generate significant free cash flow to equity (FCFE). Which of the following adjustments would typically be made to net income to arrive at FCFE?
- AAdd back non-cash charges, subtract capital expenditures, subtract change in working capital, and add back net borrowing.
- BAdd back non-cash charges, add back interest expense (net of tax), subtract capital expenditures, and subtract change in working capital.
- CAdd back non-cash charges, subtract capital expenditures, and subtract change in working capital.
- DAdd back non-cash charges, add back interest expense (net of tax), subtract capital expenditures, subtract change in working capital, and add back net borrowing.
Show answer & explanationAnswer & explanation
Correct answer: A. Add back non-cash charges, subtract capital expenditures, subtract change in working capital, and add back net borrowing.
To calculate FCFE, you start with Net Income, add back non-cash charges (like depreciation and amortization), subtract capital expenditures (CapEx), subtract the change in working capital, and then add back net borrowing (new debt issued minus debt repaid). This formula represents the cash flow available to equity holders after all expenses, investments, and debt obligations are met.
Why the other options are wrong
- B. Adding back interest expense (net of tax) is done for Free Cash Flow to Firm (FCFF) because FCFF is before any payments to debt holders. FCFE is after debt payments, so interest expense is already captured in net income.
- C. This is close to FCFF, but FCFE requires adding back net borrowing.
- D. Adding back interest expense (net of tax) is for FCFF, not FCFE.
Free Cash Flow to Equity (FCFE) from Net Income
Free Cash Flow to Equity (FCFE) is the cash flow available to equity holders after all expenses, reinvestment needs (CapEx and working capital), and net debt payments have been accounted for. It can be calculated from Net Income by adding back non-cash charges, subtracting CapEx, subtracting change in working capital, and adding back net borrowing.
- FCFE = NI + NCC - CapEx - ΔWC + Net Borrowing.
- Represents cash available to equity investors.
- Used in equity valuation models.
- Unlike FCFF, it is after interest payments and includes net debt changes.
Memory trick: FCFE: 'NI + NCC - C - W + B' (Net Income, Non-Cash, CapEx, Working Capital, Borrowing).