Calculating Free Cash Flow to the Firm: Method #2: Cash Flow From Operations
February 12, 2025
The concept of strategic finance relates to making decisions that help the firm increase its cash flow in the long run. Strategic finance is about changing the focus from short-term profits to long-term value creation. On the other hand, sustainability is about including more stakeholders in the value creation process. For instance, in the past, […]
Pension funds are large investment funds that control trillions of dollars worth of investments worldwide. Pension funds exist in almost every important economy of the world. Hence, pension funds are controlled by many different types of regulators. Despite this heavy policing of the activities of pension funds by regulatory bodies, they still face a lot […]
The banking system forms the bedrock of any financial system and even the entire economy. This is because the banking system channels the savings of individuals to the industrious. If there is a problem with this system, both the individuals and the business class are likely to be seriously affected. Therefore, maintaining the health of […]
Reserve requirements are one of the most important features of modern central banking. We hear about reserve requirements almost every day in the media. When central banks like the Fed change these requirements, it is said to have a huge impact on the markets. Liquidity worth billions of dollars is said to be either released […]
The press releases by the United States oil companies will have you believe that fracking is the best thing that has been discovered since “fire”! The newspapers are full of praise for the new technique and how it is likely to bring back the glorious days when America was self-reliant with regards to energy. However, […]
In the previous few articles we understood how to calculate free cash flows which accrue to the firm as a whole as well as to equity shareholders. However, while conducting this analysis we made an implicit assumption. We assumed that there are only two classes of funds available to the firm, this is equity and debt.
This assumption is good in the theoretical world. It helps us form a basic understanding of how free cash flows work. However, this is not how it works in real life. In real life, many hybrid modes of finance can possibly be used. One of the commonly used modes is preferred shares.
Just to refresh your memory, preferred shares behave partly like debt and partly like equity. They have a fixed rate of return. However, it is not mandatory for the company to pay this fixed dividend if there is no profit in the current year.
In this article, we will concentrate on how preferred shares affect the calculation of free cash flows.
As far as the cash flows are concerned preferred shares must be treated like debt. This is because they have a fixed rate of return and in most circumstances companies will end up paying the dividend that is fixed on them. The similarity to debt makes this assumption realistic.
However, there is a subtle difference between the treatments of interest paid on debt and dividends paid on preferred shares. Interest paid on debt is tax deductible. However, legally preferred shares are considered to be a part of equity. It is for this reason that any compensation paid to the preferred shareholders is not considered as an expense for tax purposes.
In simple words, preferred shares are not tax deductible. This makes it necessary to make certain modifications while calculating the free cash flow due to equity as well as to the firm. Let’s discuss these modifications:
The procedure to calculate the free cash flow to the firm (FCFF) remains the same. The only difference lies in the following adjustments:
Now, since there are three different modes of financing with three different costs, obviously our WACC will be the weighted average of all the three modes!
While calculating free cash flow to equity, we have to use adjustment number one mentioned above i.e. add back preferred dividends. However, we must not use adjustment number two. This is because free cash flow to equity is discounted at cost of equity. It is not discounted at WACC.
However, there is another adjustment that is specific to the calculation of free cash flow to equity. The same has been mentioned below:
All repayments need to be subtracted from the free cash flow to equity whereas any cash raised by new issue of preferred shares must be added to the cash flows. Once again, we need to consider the net change in the position of preferred equity if the firm is issuing more shares and repurchasing the old ones simultaneously.
To sum it up, preferred equity is a fairly common mode of financing used by companies. The adjustments that need to be made to the standard process of calculating free cash flows are very intuitive and minor. If a student is well versed with calculating free cash flows, the inclusion of preferred equity will not make much of a difference.
Your email address will not be published. Required fields are marked *