In Practice Estimating the FCFE at a Financial Service Firm

The standard definition of free cash flows to equity is straightforward to put into practice for most manufacturing firms, since the net capital expenditures, non-cash working capital needs and debt ratio can be estimated from the financial statements. In contrast, the estimation of free cash flows to equity is difficult for financial service firms, due to several reasons. First, estimating net capital expenditures and non-cash working capital for a bank or insurance company is difficult to do, since all of the assets and liabilites are in the form of financial claims. Second, it is difficult to define short-term debt for financial service firms, again due to the complexity of their balance sheets.

To estimate the FCFE for a bank, we begin by categorizing the income earned into three categories - net interest income from taking deposits and lending them out a higher interest rate, arbitrage income from buying financial claims (at a lower price) and selling financial claims (of equivalent risk) at a higher price and advisory and fee income from providing financial advice and services to firms. For each of these sources of income, we traced the equity investment that would be needed:

Type of Income Net Investment Needed Net Interest Income Net Loans - Total Deposits

Arbitrage Income Investments in Financial Assets - Corresponding Financial Liabilities

Advisory Income Training Expenses

(Net Loans = Total Loans - Bad Debt Provisions)

The first two categories of net investment can usually be obtained from the balance sheet, and changes in these net figures from year to year can be treated as the equivalent of net capital expenditures. While, in theory, training expenses should be capitalized and treated as tax-deductible capital expenditures, they are seldom shown in enough detail at most firms for this to be feasible.

Illustration 11.2: Estimating Free Cash Flows to Equity - Disney, Aracruz and Deutsche Bank

In Table 11.4, we estimate the free cash flows to equity for Disney from 1994 to 2003, using historical information from their financial statements.

Table 11.4: Estimates of Free Cashflows to Equity for Disney: 1994-2003


Net Income


Capital Expenditures

Change in non-cash WC

FCFE (before debt CF)

Net CF from Debt

FCFE (after Debt CF)

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