Construction of Free Cash Flows: A Pedagogical Note. Part Ii

Abstract

This is the second part of a paper where the construction of the free cash flow is studied. Usually a great deal of effort is given in typical financial textbooks to the mechanics of the calculations of time value of money equivalencies: payments, future values, present values, etc. This is necessary. However less or no effort is devoted to how to arrive at the figures required to calculate the Net Present Value NPV or the Internal Rate of Return, IRR. In Part I, a procedure for projecting pro forma financial statements (Balance Sheet (BS), Profit and Loses Statement (P&L) and Cash Budget (CB) is presented. From the CB, the Free Cash Flow FCF, the Cash Flow to Equity CFE and the Cash Flow to Debt CFD, are derived. Emphasis is done to the reasons why some items found in the P&L and CB are no included in the FCF. Also, the FCF and the CFD are calculated with the typical approach found in the literature: from the P&L and it is specified how to construct them. In doing this, working capital is redefined: the result is that it has to include and exclude some items that are not taken into account in the traditional methods. In Part II a comparison between the proposed method to construct the above-mentioned cash flows and the ones found in the current and typical textbooks is presented. Textbooks studied include Blank and Tarquin, 1998, Brealey, Myers and Marcus 1995, Copeland et.al. 1995, Damodaran, 1996, Gallaher and Andrew, 2000, and Weston and Copeland, 1992.

Note: The ideas on this paper are under revision. If the reader is interested in obtaining a new version, contact the author at [e-mail].

JEL Classification: D92, E22, E31, G31, M41