How do you calculate FCFE starting from net income, and why do we add back depreciation but subtract net capex?
CFA Level II free cash flow valuation. I have the formula FCFE = NI + Dep - Capex - Change in WC + Net Borrowing, but I don't intuitively understand each adjustment. Why add depreciation if it's a non-cash charge? And how does net borrowing fit in -- isn't FCFE supposed to be equity cash flow?
Understanding the FCFE derivation intuitively is crucial for CFA Level II -- the exam frequently tests whether you truly understand each component rather than just memorizing the formula.
The Complete FCFE Formula from Net Income
FCFE = Net Income + Depreciation & Amortization - Capital Expenditures - Change in Working Capital + Net Borrowing
Why Each Adjustment Exists
- +Depreciation: Net income deducted depreciation as an expense, but no cash actually left the company. We add it back to convert from accrual profit to cash profit. (The actual cash outflow happened when the asset was purchased -- that's captured in capex.)
- -Capital Expenditures: This is the real cash spent on fixed assets. Depreciation was the accounting allocation; capex is the actual check written. Net effect of (+Dep - Capex) replaces the accounting depreciation with the true cash investment.
- -Change in Working Capital: If accounts receivable increased by $10M, you earned that revenue (in NI) but haven't collected the cash yet. Similarly, if inventory grew, you spent cash buying goods that aren't yet sold. This adjustment captures cash tied up in the operating cycle.
- +Net Borrowing: This is the key difference between FCFF and FCFE. FCFE is cash available to equity holders after debt obligations. If the company borrows $50M to fund a $120M factory, equity holders only need to provide $70M. The net borrowing adjustment recognizes that debt holders share the funding burden.
Worked Example: Fairhaven Industrials (fictional)
| Item | Amount |
|---|---|
| Net income | $85M |
| Depreciation | $30M |
| Capital expenditures | $55M |
| Increase in accounts receivable | $8M |
| Decrease in inventory | $3M |
| Increase in accounts payable | $5M |
| New long-term debt issued | $40M |
| Debt repayments | $15M |
Change in WC = +$8M (AR up) - $3M (inventory down) - $5M (AP up) = $0M
Net borrowing = $40M - $15M = $25M
FCFE = $85M + $30M - $55M - $0M + $25M = $85M
Relationship to FCFF
FCFE = FCFF - Interest(1 - t) + Net Borrowing
This is another common exam formula. FCFF belongs to all capital providers; subtract the after-tax interest (debt holders' share) and add back net borrowing to get what's left for equity.
Exam Pitfall: A frequent trap is the sign convention for working capital. An increase in current assets uses cash (subtract), while an increase in current liabilities provides cash (add). Students often reverse these.
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