Free Cash Flow

Earlier in this chapter, we defined net cash flow as net income plus noncash adjustments, which typically means net income plus depreciation. Note, though, that cash flows cannot be maintained over time unless depreciated fixed assets are replaced, so management is not completely free to use its cash flows however it chooses. Therefore, we now define another term, free cash flow (FCF), which is the cash flow

7For firms with a more complicated tax situation, it is better to define NOPAT as follows: NOPAT = (Net income before preferred dividends) + (Net interest expense)(1 — Tax rate). Also, if firms are able to defer paying some of their taxes, perhaps by the use of accelerated depreciation, then NOPAT should be adjusted to reflect the taxes that the company actually paid on its operating income. The Copeland et al. and Stewart books listed in the references at the end of the chapter explain in detail these and other adjustments.

actually available for distribution to investors after the company has made all the investments in fixed assets and working capital necessary to sustain ongoing operations.

When you studied income statements in accounting, the emphasis was probably on the firm's net income, which is its accounting profit. However, the value of a company's operations is determined by the stream of cash flows that the operations will generate now and in the future. To be more specific, the value of operations depends on all the future expected free cash flows (FCF), defined as after-tax operating profit minus the amount of new investment in working capital and fixed assets necessary to sustain the business. Thus, free cash flow represents the cash that is actually available for distribution to investors. Therefore, the way for managers to make their companies more valuable is to increase their free cash flow.

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