The Correct Definition for the Cash Flows to Value a Firm (Free Cash Flow and Cash Flow to Equity)

Abstract

Surprisingly there is a wide range of interpretations on how to calculate the cash flows for valuation purposes. This ample definition of what the cash flows are is shared by academicians and practitioners. Some of the definitions openly contradict the essential and basic concepts of cash flow and time value of money.

In this note we specify very clearly what has to be included in those cash flows and the reasons why they should be included.

The main issue is related to the inclusion or exclusion of some items in the working capital and the current practice to consider that funds that appear in the Balance Sheet (cash and market securities and the like) belong to the free cash flow FCF and the cash flow to equity CFE. In the same line of reasoning, the idea is that cash flows have to be consistent with financial statements. With a hypothetical example we show the implicit financial facts reflected in the financial statements behind the practice of including as cash flow items that appear in the Balance Sheet.

Note: The Spanish version is available at: http://ssrn.com/abstract=642664

Keywords: Cash flows, free cash flow, cash flow to equity, valuation, levered value, levered equity value, cash budget

JEL Classification: G31, G12