Corporate and Project Finance Modeling

Chapter 9Moving from Pretax Cash Flow to After-Tax Free Cash Flow

You may reject the theory proposed by Miller and Modigliani or you may be a true believer in free cash flow and the irrelevance of the financial structure when assessing investment value. No matter what your opinion of the theory itself, the general approach of separating calculations between operations and financing that these two professors developed is central to the structure of any financial model. The structure of a model (with the exception of financial institution models) becomes much more logical and rigorous when free cash flow is calculated first and only afterward are the debt and equity split in the cash flows included. Once free cash flow is computed from EBITDA less capital expenditures, working capital changes, operating taxes, changes in deferred taxes, and changes in warranty and other provisions, a host of valuations and financial statistics can also be calculated.

In a project finance model the project internal rate of return (project IRR) (but not the equity IRR) can be computed from free cash flow and the value of the project assets at different sale dates. In a corporate finance model the return on invested capital (but not the return on equity) can be derived and the discounted cash flow value can be established with the after-tax free cash flow. Given the usefulness of starting with after-tax operating cash flow and then later splitting that cash flow into debt and equity cash flow, this ...