Deriving the Free Cash Flow (FCF) for Firm Valuation - Why We Should Include the Change in Non-Operational Working Capital in the Net Working Capital Calculation When Deriving the FCF

Abstract

By excluding the change in non-operational working capital in calculating the net working capital for the FCF, analysts create a hypothetical or ‘virtual’ cash flow. This may, or may not, be feasible given the firm’s business plan, as funds may be earmarked for future capex, or other purposes.

If management were to distribute what are in effect ‘restricted’ assets this might also seriously impair the ability of the firm to operate as a going concern.

Lastly, from a consistency point of view, the Cash Flow to Equity is also wrongly inflated leading to other valuation errors.

This note outlines an improvement on the current ‘practitioners’ approach using the free cash flow valuation methodology.

Keywords: discounted cash flows, free cash flow, WACC, net working capital, operational working capital, non-operational working capital

JEL Classification: G12, G32, M40, M41