A financial analyst is modeling the future performance of a mature manufacturing company, 'Industrial Gears Inc.' The analyst is focusing on the company's free cash flow to firm (FCFF) and notes that the company has significant capital expenditures but also substantial non-cash depreciation expense. The analyst has already calculated operating income (EBIT), the tax rate, and net capital expenditures (CapEx - Proceeds from asset sales). Which of the following adjustments is necessary to accurately derive FCFF from after-tax operating income (EBIT * (1 - Tax Rate))?
- ASubtract depreciation, add back amortization, and subtract the change in working capital.
- BAdd back depreciation and amortization, then subtract the change in working capital.
- CSubtract depreciation and add back amortization.
- DAdd back depreciation and amortization, subtract net capital expenditures, and subtract the change in working capital.
Show answer & explanationAnswer & explanation
Correct answer: D. Add back depreciation and amortization, subtract net capital expenditures, and subtract the change in working capital.
FCFF is the cash flow available to all capital providers. Starting from after-tax operating income (EBIT * (1 - Tax Rate)), we need to add back non-cash expenses like depreciation and amortization (since they reduced EBIT but are not cash outflows), subtract actual cash outlays for capital expenditures, and subtract any increases in working capital (which represent cash tied up in operations).
Why the other options are wrong
- A. Incorrect. Depreciation should be added back, not subtracted.
- B. Incorrect. This omits the deduction for capital expenditures, which are a crucial cash outflow for maintaining and expanding operations.
- C. Incorrect. Depreciation and amortization are non-cash expenses and should be added back, not subtracted, when going from EBIT to cash flow.
FCFF Derivation from EBIT
Free Cash Flow to Firm (FCFF) represents the total cash flow generated by a company's operations that is available to all capital providers (debt and equity holders) after accounting for all operating expenses and investments in working capital and fixed assets.
- FCFF = Net Income + Non-Cash Charges + Interest Expense(1-T) - FCInv - WCInv (or various other starting points).
- From EBIT: FCFF = EBIT(1 - Tax Rate) + Depreciation & Amortization - Capital Expenditures - Change in Working Capital.
- Depreciation and Amortization are added back as they are non-cash expenses.
- Capital Expenditures (FCInv) are subtracted as they are cash outflows for long-term assets.
- Change in Working Capital (WCInv) is subtracted if positive (cash outflow) or added if negative (cash inflow).
Memory trick: EBIT's after-tax, add back the non-cash, subtract the real cash investments in growth and working capital.