When valuing the operations of a firm using a discounted cash flow model, the operating cash flow is needed. This operating cash flow also is called the unlevered free cash flow (UFCF). The term “free cash flow” is used because this cash is free to be paid back to the suppliers of capital.
Calculating Free Cash Flow
For a particular year, the unlevered free cash flow is calculated as follows:
1. Start with the annual sales and subtract cash costs and depreciation to calculate the earnings before interest and taxes (EBIT). The EBIT also is referred to as the operating income and represents the pre-tax earnings without regard to how the business is financed.
2. Calculate the earnings before interest and after tax (EBIAT) by multiplying the EBIT by one minus the tax rate. Note that the EBIAT represents the after-tax earnings of the firm as if it were financed entirely with equity capital.
3. To arrive at the UFCF, add the depreciation expense back to the EBIAT, and subtract capital expenditures (CAPEX) that were not charged against earnings and subtract any investments in net working capital (NWC).
The free cash flow calculation in equation form:
Operating Income (EBIT) = Revenues – Cash Costs – Depreciation Expense
EBIAT = EBIT – Taxes, where Taxes = (tax rate)(EBIT)
UFCF = EBIAT + Depreciation Expense – CAPEX – Increase in NWC
Capital expenditures are calculated by solving for CAPEX in the following equation:
BV of Assets at Year End = BV of assets at Beginning of Year
An additional cash adjustment may be necessary for an increase in deferred taxes that would have a positive impact on cash flow.