Free Cash Flows

Free cash flow is defined as the amount of cash generated from a company's operating activities and investing activities plus the after-tax cost of the interest expense. These amounts are derived from the statement of cash flows. Earlier we mentioned that the AICPA's version of the statement of cash flows is slightly different from the one presented in Exhibit 6.1. One of those differences is that the interest and income tax expenses for the period reported are footnoted at the bottom of the AICPA statement.

Accordingly, you would take the interest expense figure and subtract the tax deduction for that expense. Remember, calculating the effective tax rate is as simple as dividing the income taxes by the sum of net income and the income taxes.

The amount of free cash flows is a determinant of value of a company. The greater the magnitude of the free cash flows, the more valuable the company becomes. This is a different perspective from Chapter 5, where economic value added (EVA) measures the value created or lost on a year-by-year basis.

If a statement of cash flows is not readily available, finance academics have come up with formulas for shortcutting the process. Exhibit 6.3 provides the formula and the key for the abbreviations.

FCF = OCF – Change in NWC – CAPEX FCF = Free Cash Flows OCF = Operating Cash Flows NWC = Net Working Capital CAPEX = Capital Expenditures |

Operating cash flows is defined as the after-tax annual earnings ...

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