Construction of Free Cash Flows: A Pedagogical Note. Part I
23 Pages Posted: 2 Dec 1999
Date Written: January 2001
This is the first part of a paper where the construction of the free cash flow is studied. Usually a great deal of effort is devoted in typical financial textbooks to the mechanics of the calculations of time value of money equivalencies: payments, future values, present values, etc. This is necessary. However less or no effort is devoted to how to arrive at the figures that serve to calculate a NPV or Internal Rate of Return, IRR. In Part I, pro forma financial statements (Balance Sheet (BS), Profit and Loses Statement (P&L) and Cash Budget (CB) are presented. From the CB, the Free Cash Flow FCF, the Cash Flow to Equity CFE and the Cash Flow to Debt CFD, are derived. Emphasis is done to the reasons why some items included in the P&L and CB are no included in the FCF. Also, the FCF and the CFD are calculated with the typical approach found in the literature: from the P&L and it is specified how to construct them. In doing this, it is necessary to redefine working capital: the result is that it has to include and exclude some items that are not taken into account in the traditional methods. In Part II a comparison between the proposed method to construct the above-mentioned cash flows and the ones found in the current and typical textbooks is presented.
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Keywords: Free cash flow; Cash flow to equity; Cash flow to debt; Project evalaution; Firm valuation; Investment valuation; Net Present Value, NPV assumptions
JEL Classification: D92, E22, E31, G31, M41
Suggested Citation: Suggested Citation