Top Stories | Wed, 18 Dec 2024 06:12 PM

Top 20 Free Cash Flow to Firm(FCFF) Interview Q&A

Posted by : SHALINI SHARMA

1. What is Free Cash Flow to Firm (FCFF), and how does it differ from Free Cash Flow to Equity (FCFE)?

 FCFF is cash that is available to all capital providers of a company, that is, both debt holders and equity holders. This cash flow can be derived as follows: EBIT maybe further adjusted for taxes, working capital changes, and capital expenditures but before any payment is made of debts. On the other hand, FCFE refers to fund available to the equity shareholders, after the debt repayments, interest payments, and new borrowings made on behalf of the company. So, while FCFF is concerned with both debt and equity financing, FCFE is concerned only with equity financing.

2. What is the procedure for determining FCFF, including what condition modifications may apply to EBIT?

To calculate FCFF, the formula is:

FCFF= EBIT (1−Tax Rate) +Depreciation−Change in Working Capital−Capital Expenditure

To convert EBIT into FCFF, one has to modify the figures of EBIT for making appropriate allowances for those non-cash costs-depreciation in this case-and alterations in net working capital as well as capital expenditure on investments in long-lived assets. This formula excludes the interest payments because FCFF is the case which is available to the capital providers and not only to the equity shareholders.

3. Why is FCFF important in valuation?

Valuation of a company fundamentally rests on the ability of FCFF to evaluate cash earned by a company from its operations before being apportioned among investors (debt and equity). It uses discounted cash flow (DCF) models in deriving the overall value of the organization that is later adjusted with the value of debt to derive equity value. This component being comprehensive (for both debt and equity), gives a better measure of whether the financial health of a company is solid or shaky, especially in cases where a considerable level of debt exists for the firm.

4. In what ways does the use of FCFF for valuation purposes have limitations?

Sensitive Assumptions: The computation of free cash flow to the firm is dependent on critical variables such as tax rates, capital expenditure, and net working capital, which vary with time. 

Non-cash charges include depreciation: Adjustment for the depreciation or non-cash charges might not actually reflect cash flow generation in the real sense, particularly for capital-intensive industries.

Full capital structure: Free cash flow to the firm does not speak about any structural changes into the capital of the company like huge debt levels or even refinancing's that will tend to distort the free cash flow available to the capital providers.

5. How to Adjust FCFF if the Company has Income or Non-operating Expense?

 Non-operating income and expenses should be excluded from the calculation of FCFF because they are not related to the firm's core business operations. These include gains or losses from the sale of assets, interest income, or income from investments. For a more accurate FCFF, it is import to focus on operating performance and exclude these one-time items that do not reflect the ongoing cash generation ability of the company.

6. Is it possible for FCFF to register a negative value? What does this show?

Yes, FCFF can be negative, which means that the company lacks enough cash inflow to meet operating expenses as well as investments, or it invests excessively in the business (increased capital expenditures or working capital). A negative FCFF could indicate financial woes and the requirement for outside financing through more debt or equity.

7. How would you incorporate FCFF in a DCF valuation model?

In a Discounted Cash Flow (DCF) model, the cash flow figure would use FCFF, which would then be discounted back to present value using WACC to arrive at total enterprise value (EV) of the firm. After this, net debt would be deducted from the enterprise value to arrive at the equity value of the firm. FCFF in a DCF model would serve as a proxy to future free cash flow of the company available to all investors, hence applying the appropriate discount rate (WACC).

8. How is FCFF impacted by a working capital change? 

 The change in working capital refers to the improvement or deterioration of current assets and liabilities causing an increase or decrease in the FCFF. Thus, an increase in working capital like a rise in the position of accounts receivable or rise in inventory reduces available cash and decreases the FCFF, while decreases in working capital, like a downtrend in accounts receivable or decreasing inventory, release cash for use and increase the FCFF. Change in working capital reflects the efficiency level of the firm in managing its short-term assets and liabilities.

9. What would you say concerning the treatment of lease payments in the FCFF calculation?

 Under finance leases following IFRS 16, there is now an interest component in the lease payment and an amortized portion that is added to EBIT while computing FCFF. Prior to IFRS 16, leases were operating leases and the rental expense was just included in the income statement, leaving no adjustments to be made for FCFF. In other words, under operating leases, lease payments are not included in FCFF computation, whereas under finance leases, only the amortized portion is considered.

So, in an operating lease situation, rent expense will be treated as part of EBIT without adjustment to FCFF. In the case of a finance type lease, the interest portion would be excluded from EBIT, and thus this would not be added back; instead, the amortized portion of the lease expense would be considered, along with amortization from the principal portion.

10. Should companies with no debt use FCFF?

FCFF can also be used for these types of companies. Since there will be no interest payments and therefore no debt-related adjustment entries, FCFF will equal FCFE. Even for non-levered firms, FCFF measures the cash flow produced through business operations, which then allows valuing the firm based on its operating performance and capital expenditures.

11. In what ways does capital structure change influence FCFF? 

Answer: FCFF calculation is done prior to any interest payment, therefore, no changes in capital structure of the company (debt or equity) will have any direct effect on FCFF. However, changes in capital structures are very much significant for WACC and hence for enterprise value using DCF model. Since an increase in debt increases costs (debt cost is lower, generally) may bring down WACC, thereby increasing firm value, but no effect on changes in financing is FCFF.

12. How would you treat a situation in which a company has a significant one-time expense or very large non-recurring item in its financial statements? 

All non-recurring or one-time expenses such as restructuring costs, or asset impairments should be taken out of EBIT in the calculation of FCFF, as these expenses will not reflect cash flow during the company’s ongoing operations. By making these adjustments, it is certain that FCFF is representative of the firm’s core-business performance, thereby rendering it more realistic and useful for valuation cash flow projection.

13. How does one forecast free cash flows to the firm for a company that faces volatile working capital requirements?

 In forecasting the FCFFs for a company with variable working capital, the best approach would be modeling working capital changes according to historical trends, industry averages, and the company's growth patterns. For instance, average changes in working capital may be computed as a percentage of revenue or changes to working capital may be connected with expected growth rates in sales. In addition, the company's cycles of operation are usually significant, as many cyclical companies may have much larger variation in levels of working capital.

14. What is the significance of the tax rate in FCFF, and how should it be handled if the company has tax loss carryforwards?

Tax rate is significant to FCFF since the measure is a tax-adjusted EBIT that provides information about cash flow available to capital providers after taxes. Future taxable income may be reduced by tax loss carryforwards, resulting in a future tax payment reduction that may affect the calculation of FCFF. In this case, analysts should modify the tax rate for the tax savings due to carryforward by either effective tax rate application or forecasting the timing of the utilization of previously accrued asset loss.

15. In the context of DCF Valuation, what are the important distinctions pertaining to using the FCFF and FCFE in choosing a discount rate? 

When valuing using FCFF in the DCF valuation method, the appropriate discount rate to apply is Weighted Average Cost of Capital because FCFF represents the cash flow available to all capital providers (debt and equity). On the other hand, FCFE requires the cost of equity as a discount rate in that it represents available cash flow only to equity holders. Hence, the different discount rates apply depending on the cash flows considered, whether FCFF or FCFE, and from what perspective of the capital provider.

16. How would you make a case for a firm that is heavily into capital expenditures (Capex) without generating positive FCFF? 

 Typically, a firm deeply into capital expenditures but not producing positive FCFF is a growth firm and that is spending severely in future capacity, product development, or expansion. Analysts will need to ask whether the short term negative free cash flow generated will be sustainable and what the returns will be from investments. Future projections of free cash flow would also include expected benefits of capital expenditures in the future in terms of revenue growth or improved margins, which eventually should lead to free cash flow being positive over the long run. The negative FCFF is potentially a short phase and can be expected to turn positive as the business matures.

17. What would you consider while adjusting FCFF in the case of a company located in a foreign jurisdiction and having different tax rates across countries?

 FCFF for any multinational corporation has to be calculated on a consolidated basis, applying the relevant tax rates for each jurisdiction. This involves adjusting EBIT differently for the effective tax rate in different countries where the multinational operates. Certainly, correct application of effective tax rates needs to be based on the specific jurisdiction’s tax laws and tax treaties if the corporation is doing a substantial amount of business in several tax jurisdictions with quite different rates, as they would impact the overall calculation of FCFF.

18. Can FCFF can be used for distressed companies or companies undergoing bankruptcy proceedings?

However, because of an unstable and unreliable expectation of future cash flows, earnings, and recovery possibilities, the valuation may be quite untrustworthy. Therefore, FCFF projection in this situation is very complex and adjustments must be done with respect to the restructuring program, the divestment of assets, or liquidation values of the company. In fact, it is highly likely that cost of capital (WACC) may go up in distressed scenarios, thus affecting the DCF-based valuations of FCFF pretty significantly.

19. How to account for pension liabilities on calculating FCFF? 

 If the pension liability represents a real material cash flow outflow for the company, such a pension liability should be factored into the calculation of FCFF. This additional requirement of funds will therefore reduce the amount of FCFF where increased pension obligations occurred. The same would apply in the opposite direction; the reduction of pension liability or overfunding of the pension may release cash, increasing FCFF. Changes in pension liabilities should be included in the FCFF model either as part of working capital changes or as direct outflows.

20. How does the presence of substantial non-operating assets (such as real estate holdings or balance sheets of large cash) influence FCFF calculations?

 The reason for the exclusion of non-operating assets-i.e. real estate holdings or large cash balances-in the calculation of FCFF is that these assets do not pertain to the real operations of the business. FCFF accounts for the business cash-generating operations and investments in working capital and capital expenditure. Even if non-operating assets would generate some form of cash flow, they are irrelevant for the free cash flow from operations calculation. Analysts valuing using FCFF should close any gaps in the non-operating asset valuation usually added to the FCFF-based computation of enterprise value.