Free Cash Flow

When valuing the operations of a firm using a discounted cash flow model, the
operating cash flow is needed. This operating cash flow also is called the unlevered
free cash flow (UFCF). The term "free cash flow" is used because this cash is free to
be paid back to the suppliers of capital.

Calculating Free Cash Flow

For a particular year, the unlevered free cash flow is calculated as follows:

1. Start with the annual sales and subtract cash costs and depreciation to calculate
the earnings before interest and taxes (EBIT). The EBIT also is referred to as the
operating income and represents the pre-tax earnings without regard to how the
business is financed.
2. Calculate the earnings before interest and after tax (EBIAT) by multiplying the
EBIT by one minus the tax rate. Note that the EBIAT represents the after-tax
earnings of the firm as if it were financed entirely with equity capital.
3. To arrive at the UFCF, add the depreciation expense back to the EBIAT, and
subtract capital expenditures (CAPEX) that were not charged against earnings
and subtract any investments in net working capital (NWC).

The free cash flow calculation in equation form:

Operating Income (EBIT)   =   Revenues   –   Cash Costs   –   Depreciation Expense

EBIAT  =  EBIT  –  Taxes,    where Taxes = (tax rate)(EBIT)

UFCF  =  EBIAT  +  Depreciation Expense  –  CAPEX  –  Increase in NWC

Capital expenditures are calculated by solving for CAPEX in the following equation:

BV of Assets at Year End = BV of assets at Beginning of Year

    +  CAPEX
    –  Depreciation

An additional cash adjustment may be necessary for an increase in deferred taxes that
would have a positive impact on cash flow