Finding FCFF and FCFE from EBIT or EBITDA

Think about how you'd tackle finding free cash flow amounts for a company like Loews Corporation, a global conglomerate in oil and financial services. Not only could you calculate FCFF from net income and cash flow from operations, you could also use earnings before interest and taxes (EBIT) or earnings before interest, taxes, depreciation, and amortization (EBITDA).

Using EBIT and/or EBITDA would involve adjusting the previous free-cash-flow ratios. Start with EBIT and net income. That adjustment would naturally involve interest and taxes, but recall that FCFF includes interest, so since interest hasn't been subtracted yet from EBIT, it's still in there. So in this case, the adjustment is simple. How would you adjust a company's EBIT for taxes?

That's it! EBIT needs to be adjusted to remove taxes. $$\displaystyle \mbox{EBIT} \times (1-\mbox{Tax Rate})$$ And since interest expense hasn't been subtracted, use the full formula for FCFF from EBIT. $$\displaystyle \mbox{FCFF}= \mbox{EBIT} \times (1-\mbox{Tax Rate}) + \mbox{Dep} - \mbox{FCInv} - \mbox{WCInv}$$

Not quite. Taxes haven't been charged yet.

No. FCFF is an after-tax value, so taxes require an adjustment.

So that's a good starting point thinking about how EBITDA would impact the FCFF calculation. The company's EBITDA would also require the tax impact adjustment, so that's straightforward. $$\displaystyle \mbox{EBITDA} \times (1-\mbox{Tax Rate})$$ But in this case, EBITDA might also need another specific adjustment. What do you think that involves?

You got it! Recall that depreciation gives companies a tax benefit because it's a noncash charge that reduces taxable income. So that tax benefit needs to be added to the EBITDA FCFF calculation. That's because while EBITDA excludes the amortization and depreciation charges, it does need to be adjusted for taxes. That EBITDA amount is reduced for taxes on the entire amount, which wipes out the depreciation tax benefit, so it must be added back.

No. Interest is already taken care of because it hasn't been subtracted from the earnings yet. There's no need for an interest expense adjustment.

Not quite. Depreciation and amortization haven't been subtracted from earnings, so that adjustment isn't necessary.

So including the tax and depreciation adjustments, use the formula for calculating a company's FCFF from EBITDA. $$\displaystyle \mbox{FCFF} = \mbox{EBITDA} \times (1-\mbox{Tax Rate}) + \mbox{Dep}(\mbox{Tax Rate}) - \mbox{FCInv} - \mbox{WCInv}$$ Note that when using EBIT or EBITDA, taxes are a big factor in calculating FCFF.

And to compute the company's FCFE from EBIT or EBITDA, the easiest way is to use the FCFF formulas and simply adjust for interest and net borrowing. $$\displaystyle \mbox{FCFE} = \mbox{FCFF} - \mbox{Int} \times (1-\mbox{Tax Rate}) + \mbox{Net Borrowing}$$

To summarize: [[summary]]

Remove taxes

Add back taxes paid

No adjustment necessary

A depreciation tax adjustment

An after-tax interest expense adjustment

An add back of depreciation and amortization

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