## Computing FCFF from Net Income

FCFF is the cash flow available to the company’s suppliers of capital after all operating expenses (including taxes) have been paid and operating investments have been made. The company’s suppliers of capital include bondholders and common shareholders (plus, occasionally, holders of preferred stock, which we ignore until later). Keeping in mind that a noncash charge is a charge or expense that does not involve the outlay of cash, we can write the expression for FCFF as follows:

FCFF = Net income available to common shareholders (NI)
Plus: Net noncash charges (NCC)
Plus: Interest expense × (1 − Tax rate)
Less: Investment in fixed capital (FCInv)
Less: Investment in working capital (WCInv)

This equation can be written more compactly as: FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv

Consider each component of FCFF. The starting point in the equation above is net income available to common shareholders—the bottom line in an income statement. It represents income after depreciation, amortization, interest expense, income taxes, and the payment of dividends to preferred shareholders (but not payment of dividends to common shareholders).

Net noncash charges represent an adjustment for noncash decreases and increases in net income. This adjustment is the first of several that analysts generally perform on a net basis. If noncash decreases in net income exceed the increases, as is usually the case, the adjustment is positive. If noncash increases exceed noncash decreases, the adjustment is negative. The most common noncash charge is depreciation expense. When a company purchases fixed capital, such as equipment, the balance sheet reflects a cash outflow at the time of the purchase. In subsequent periods, the company records depreciation expense as the asset is used. The depreciation expense reduces net income but is not a cash outflow. Depreciation expense is thus one (the most common) noncash charge that must be added back in computing FCFF. In the case of intangible assets, there is a similar noncash charge, amortization expense, which must be added back. Other noncash charges vary from company to company.

After-tax interest expense must be added back to net income to arrive at FCFF. This step is required because interest expense net of the related tax savings was deducted in arriving at net income and because interest is a cash flow available to one of the company’s capital providers (i.e., the company’s creditors). In the United States and many other countries, interest is tax deductible (reduces taxes) for the company (borrower) and taxable for the recipient (lender). As we explain later, when we discount FCFF, we use an after-tax cost of capital. For consistency, we thus compute FCFF by using the after-tax interest paid.5

Similar to after-tax interest expense, if a company has preferred stock, dividends on that preferred stock are deducted in arriving at net income available to common shareholders. Because preferred stock dividends are also a cash flow available to one of the company’s capital providers, this item is added back to net income available to common shareholders in deriving FCFF.

## Assumptions

• Expectations are homogeneous. This means investors agree on the expected cash flows from a given investment. This means that all investors have the same expectations with respect to the cash flows from an investment in bonds or stocks.

• Bonds and shares of stock are traded in perfect capital markets. This means that there are no transactions costs, no taxes, no bankruptcy costs, and everyone has the same information. In a perfect capital market, any two investments with identical cash flow streams and risk must trade for the same price.

• Investors can borrow and lend at the risk-free rate.

• There are no agency costs. This means that managers always act to maximize shareholder wealth.

• The financing decision and the investment decision are independent of each other. This means that operating income is unaffected by changes in the capital structure.

• No costs of asymmetric information

• debtholders have prior claim to assets and income relative to equityholders, the cost of debt is less than the cost of equity