Step 1 Measuring Cash Available to be returned to Stockholders

To estimate how much cash a firm can afford to return to its stockholders, we begin with the net income — the accounting measure of the stockholders' earnings during the period — and convert it to a cash flow by subtracting out a firm's reinvestment needs. First, any capital expenditures, defined broadly to include acquistions, are subtracted from the net income, since they represent cash outflows. Depreciation and amortization, on the other hand, are added back in because they are non-cash charges. The difference between capital expenditures and depreciation is referred to as net capital expenditures and is usually a function of the growth characteristics of the firm. High-growth firms tend to have high net capital expenditures relative to earnings, whereas low-growth firms may have low, and sometimes even negative, net capital expenditures.

Second, increases in working capital drain a firm's cash flows, while decreases in working capital increase the cash flows available to equity investors. Firms that are growing fast, in industries with high working capital requirements (retailing, for instance), typically have large increases in working capital. Since we are interested in the cash flow effects, we consider only changes in non-cash working capital in this analysis.

Finally, equity investors also have to consider the effect of changes in the levels of debt on their cash flows. Repaying the principal on existing debt represents a cash outflow, but the debt repayment may be fully or partially financed by the issue of new debt, which is a cash inflow. Again, netting the repayment of old debt against the new debt issues provides a measure of the cash flow effects of changes in debt.

Allowing for the cash flow effects of net capital expenditures, changes in working capital, and net changes in debt on equity investors, we can define the cash flows left over after these changes as the free cash flow to equity (FCFE): Free Cash Flow to Equity (FCFE) = Net Income

- (Capital Expenditures - Depreciation)

- (Change in Non-cash Working Capital)

+ (New Debt Issued - Debt Repayments)

This is the cash flow available to be paid out as dividends.

This calculation can be simplified if we assume that the net capital expenditures and working capital changes are financed using a fixed mix5 of debt and equity. If 6 is the proportion of the net capital expenditures and working capital changes that is raised from debt financing, the effect on cash flows to equity of these items can be represented as follows:

5 The mix has to be fixed in book value terms. It can be varying in market value terms.

Equity Cash Flows associated with Capital Expenditure Needs = - (Capital Expenditures

Equity Cash Flows associated with Working Capital Needs = - (A Working Capital) (1-6) Accordingly, the cash flow available for equity investors after meeting capital expenditure and working capital needs is: Free Cash Flow to Equity = Net Income

- (Capital Expenditures - Depreciation) (1 - 6)

Note that the net debt payment item is eliminated, because debt repayments are financed with new debt issues to keep the debt ratio fixed. It is particularly useful to assume that a specified proportion of net capital expenditures and working capital needs will be financed with debt if the target or optimal debt ratio of the firm is used to forecast the free cash flow to equity that will be available in future periods. Alternatively, in examining past periods, we can use the firm's average debt ratio over the period to arrive at approximate free cash flows to equity.

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