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The Sunk Cost Fallacy
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Startup funding is not a one-time activity. Instead, it is a long-drawn process that encompasses many years in the initial life of any startup firm. It is important to realize that the funding of any startup company happens in multiple stages. Up until now, we have understood the pre-seed funding as well as the seed […]
Now, it’s time to move on to the second metric which can be used to derive the free cash flow to the firm (FCFF). This metric is the cash flow from operations. These types of questions involve a complete cash flow statement being provided as the question and expect the student to derive free cash flow to the firm (FCFF) as an output.
The conceptual understanding that we built in the previous article regarding the difference between these two closely related terms will come in handy here.
We already know that the difference between free cash flow to the firm (FCFF) and cash flow from operations arises because we consider long term investments as being the part of one whereas we do not consider for the other. Therefore, simply put, free cash flow to the firm (FCFF) can be derived from cash flow from operations in the following manner:
Free Cash Flow to the Firm (FCFF) = Cash flow from Operations – Net Investment in Long Term Assets
However, this is only an approximation. To consider this to be the accurate derivation of free cash flow to the firm (FCFF) would be an oversimplification.
There is another complication that is introduced because of the way we treat interest expense while preparing statement of cash flows.
We consider interest expense as a financing expense. That is because, the operating cash flows of the firm would remain the exact same regardless of whether we ran the business on own money or on borrowed money. Hence, we subtract them from operating cash flow and send them to financing cash flows.
Well, when calculating free cash flow to the firm (FCFF) the perspective changes. We are not concerned whether the money is spent because of regular operations or not. All we are concerned about is that it reduces the money available for the investors. Hence, we must add this interest expense back our above formula. Thus we arrive at a modified formula which is
FCFF = Cash flow from Operations – Net Investment in Long Term Assets + Interest Expense
However, adding back the entire interest expense would also be an oversimplification. Thus, we have one last adjustment to make before we can arrive at the free cash flow to the firm (FCFF) number. That adjustment pertains to tax. Since we have already deducted tax, the interest expenditure should be reduced to account for its effect. Thus the final formula is:
The above two formulas were only intermediate calculations to derive the final formula and must not be used. The third formula (highlighted with border) is the final formula which must be used to derive the free cash flow to the firm in case all the inputs are known.
Example:
Let’s understand this with the help of an example:
Cash flow from operations = $1000
Cash Outflow (New Machine) = $250
Cash Inflow (Sale of Old Machine) = $75
Interest Expense = $100
Tax Rate = 40%
Calculation #1: Net Cash Flow towards Long Term Assets = $250 - $75 = $175
Calculation #2: After Tax Interest Expense = $100*(1 – 0.40) = $60
Therefore,
Needless to say this is an over simplified version for explanation. The questions on the exam will be much more detailed and calculation intensive. However, the logic and the steps required to solve them remain the same.
Many students find it confusing that interest is the only financing expense that is added back to cash flow from operations. They wonder why other expenses like dividends and share repurchases do not affect the free cash flow to the firm.
The answer lies in the sequence in which the calculation happens. Interest expense was earlier subtracted to arrive at the net income. Hence, it needs to be added back.
Other expenses like dividends and share repurchase are not subtracted to arrive at the net income and hence no adjustments need to be made for them!
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