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REV: SEPTEMBER 14, 2006

DAVID SCHARFSTEIN

Calculating Free Cash Flows

The value of a firm stems from the cash flows that it generates. The attractiveness of a proposed capital expenditure, new product introduction, or licensing deal all depend on the cash flows they provide. This note describes how to calculate cash flows from historical and pro forma financial statements. Although animportant component of valuing firms and projects is generating accurate and sensible forecasts of income statement and balance sheet items—arguably it is the most important part of valuation—the focus of this note is on the mechanical process of transforming numbers from financial forecasts into cash flows. To start, it is important to distinguish between “income” and “cash flow.” Cash flow can bedefined as the cash generated by a business that can be paid out to investors. Income is not the same as cash flow for many reasons, which relate to the use of accrual accounting methods. Accrual accounting is “transactions based,” that is, it records information on financial statements when transactions occur, not necessarily when a party is paid (receives cash) for the transaction. So, forexample, a sale of an engine is recorded when it occurs, even though the customer gets trade credit and the company will not receive the cash for 30 days. Likewise, the cost of building the engine gets recorded at the time of the sale even if the expenses were incurred months earlier. These and other aspects of accrual accounting mean that we need to make various adjustments to accrual-based measuresof income to extract information about historical and pro forma cash flows. Fortunately, undoing the accrual nature of accounting statements to compute cash flow is a relatively straightforward task. This note derives the following simple formula for free cash flow for a single period, typically a year.
FCFt = (1 − τ ) × EBITt + Dept − Capxt − ∆NWCt

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In the formula above, “EBIT”denotes earnings before interest and taxes, “τ” denotes the tax rate, “Dep” denotes depreciation and amortization, “Capx” denotes capital expenditures, and “∆NWC” denotes the change in net working capital. The “t” subscript denotes the year or month; likewise, “t-1” denotes the previous year or month.

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Professors Robin Greenwood and David Scharfstein prepared this note as the basis for class discussion.

Copyright © 2005 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of thispublication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

Copying or posting is an infringement of copyright. Permissions@hbsp.harvard.edu or 617-783-7860.

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The Free Cash Flow Formula

ROBIN GREENWOOD

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Calculating Free Cash Flows

Deriving the Free Cash Flow Formula

To calculate free cash flow, we need to collect all of the sources and uses of cash of the firm. These can be simplified into five primary components:

Cash flow from sales

Cash outlay for goods

Cash operating expenses

Capital expenditures

Suppose you wanted to calculate each of these itemsfor a single year for a simple business. You might be presented with forecasts of the balance sheet at the beginning (period t-1) and end of the year (period t), as well as an income statement covering the same period. These are shown in Table A.

INCOME STATEMENT (t) Salest – COGSt – Opext = EBITDA – Dept – Taxes = EBIATt

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Assets ARt-1 Invt-1 PPEt-1 ARt Invt

Table A

Simplified...
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