Page 161 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes Free Cash Flow to Equity (FCFE) = Net Income - (Capital Expenditures - Depreciation) -
(Change in Non-cash Working Capital) + (New Debt Issued
– Debt Repayments)
This is the cash flow available to be paid out as dividends or stock buybacks. This calculation can
be simplified if we assume that the net capital expenditures and working capital changes are
financed using a fixed mix1 of debt and equity. If is the proportion of the net capital expenditures
and working capital changes that is raised from debt financing, the effect on cash flows to equity
of these items can be represented as follows:
Equity Cash Flows associated with Capital Expenditure Needs
= – (Capital Expenditures – Depreciation)(1 – )
Equity Cash Flows associated with Working Capital Needs

= – ( Working Capital)(1 – )
Accordingly, the cash flow available for equity investors after meeting capital expenditure and
working capital needs, assuming the book value of debt and equity mixture is constant, is:
Free Cash Flow to Equity = Net Income - (Capital Expenditures - Depreciation)(1 – ) -
( Working Capital)(1 - )

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Caution The net debt payment item is eliminated, because debt repayments are financed
with new debt issues to keep the debt ratio fixed. It is particularly useful to assume that a
specified proportion of net capital expenditures and working capital needs will be financed
with debt if the target or optimal debt ratio of the firm is used to forecast the free cash flow
to equity that will be available in future periods. Alternatively, in examining past periods,
we can use the firm's average debt ratio over the period to arrive at approximate free cash
flows to equity.

What about Preferred Dividends?

In both the long and short formulations of free cashflows to equity described in the section
above, we have assumed that there are no preferred dividends paid. Since the equity that we
value is only common equity, you would need to modify the formulae slightly for the existence
of preferred stock and dividends. In particular, you would subtract out the preferred dividends
to arrive at the free cashflow to equity.
Free Cash Flow to Equity (FCFE) = Net Income - (Capital Expenditures -Depreciation) -
(Change in Non-cash Working Capital) - (Preferred
Dividends + New Preferred Stock Issued) + (New Debt
Issued - Debt Repayments)
In the short form, you would obtain the following:
Free Cash Flow to Equity = Net Income - Preferred Dividend - (Capital Expenditures -
Depreciation)(1 – ) - ( Working Capital)(1 – )

The non-equity financial ratio ( ) would then have to include the expected financing from new
preferred stock issues.

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