Calculating Free Cash Flow to Firm: Method #1 (Contd): Treatment of Fixed Capital Expenditure

In the previous article we learned that free cash flow to the firm is closely related to the concept of cash flow from operations. The major difference was in the way free cash flow to the firm (FCFF) treats long term capital expenditures versus how they get treated in the regular cash flow statement.

The regular cash flow statement does not include long term capital expenditures in cash flow from operations. Rather, it includes this cash outflow in another section called cash flow from financing. The reason is that the objective is to find out the cash flow that the firm generates from its day to day operations.

However, when it comes to free cash flow to the firm the objective has changed. The objective is no longer concerned with whether the cash flow is generated from regular operating activities or from one off transactions. The objective here is to find out what is the amount of free cash flow that the shareholders of the firm will be left with at the end of the given year. Hence, in this case long term capital expenditures are included in the calculation.

This may seem like a very small difference. However, wrongly including or excluding the fixed capital expenditure is a mistake that most students make. Hence, in this article we will discuss in detail about how fixed capital needs to be treated while calculating the free cash flow to the firm.

Gross Fixed Capital Expenditure vs. Net Fixed Capital Expenditure:

Firstly, we need to clarify the concepts of gross fixed capital expenditure and net fixed capital expenditure. We intuitively know the difference between gross and net. The same logic can be applied here as well.

Gross fixed capital expenditure includes only the additions that have been made to the fixed capital in a particular accounting period. These additions could arise because of purchase of new fixed capital. Also, they could arise because of addition of improvements or repairs to the existing fixed capital which has been capitalized in the balance sheet. Hence, when it comes to “gross”, we are considering only the outflow.

Net, fixed capital expenditure, on the other hand also includes the inflows. For instance, it is possible that we may have sold some of the machinery that we have in this given year. In this case, there will be a positive inflow of cash. Hence, we must reduce our outflow by that amount to arrive at the net cash flow on capital expenditure.

Let’s understand this with the help of an example:

If we purchase a machine worth $100 in the present year and at the same time sell a machine for $20 in the same year, then:

Gross Fixed Capital Investment is $100

Whereas Net Fixed Capital Investment is, $100 - $20 i.e. $80

It is the net fixed capital investment that we are concerned with while calculating free cash flow to the firm. Hence, if we are given cash inflows and outflows separately, we need to arrive at the net figure before we can begin our calculations.

Given the above concepts, there are three possible cases that may arise. Let’s see how we must deal with them:

Case #1: No Sale of Fixed Assets

In a given period, there could be only additions to the amount of fixed assets and no subtractions i.e. no sale. This is an easy case since here gross fixed capital investment equals net fixed capital investment. We can simply use this number during our calculation of free cash flow to the firm.

Case #2: Sale of Fixed Assets

The second case is simple too. In this case, we are given the cash proceeds from sale and the cash outflow from purchase directly. In this case, we can just subtract the numbers like in the above example and arrive at the net fixed capital investment figure that we need.

Remember, this number could be positive, negative or zero!

Case #3: Sale of Fixed Assets (Indirect Derivation)

The complicated case is when the cash proceeds and the cash outflow numbers are not directly given. In such cases, we need to calculate the net cash flow from fixed capital investment in the following manner:

1. First, we need to see the difference between the opening and the closing amounts of fixed assets listed on the balance sheet. The first step is to derive the change in the fixed assets in the current year by using the formula:
   Change in Fixed Assets: Closing Balance – Opening Balance
2. We need to adjust this change for the gain or loss that was made by selling old assets. This gain or loss is not reflected on the balance sheet. Instead it is reflected on the income statement. Therefore, we need to subtract the gain and add the loss. So now, our formula is modified to
   Change in fixed Assets: Closing Balance – Opening Balance – Gain + Loss
3. Lastly, if the depreciation for the asset sold is separately mentioned and we haven’t accounted for it, we must also add this to our calculation. Ensure that you haven’t already added this depreciation earlier to avoid double counting. So, our final formula is:

Change in Fixed Assets: Closing Balance – Opening Balance – Gain + Loss + Depreciation

This calculation is the most difficult part in deriving free cash flow to the firm. A good conceptual understanding is recommended for this part to avoid errors.