Ignacio Vélez-Pareja ivelez@javeriana.edu.co Department of Management Universidad Javeriana Bogotá, Colombia Working Paper N 5

First version: 5-Nov-99 This version: January 2001

This paper can be downloaded from the

Social Science Research Network Electronic Paper Collection: http://papers.ssrn.com/paper.taf?abstract_id=196588 CONSTRUCTION OF FREE CASH FLOWS

A PEDAGOGICAL NOTE. PART I1

Ignacio Vélez-Pareja ivelez@javeriana.edu.co

ABSTRACT

This is the first part of a paper where the construction of the free cash flow is studied. Usually a great deal of effort is devoted 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 a NPV or Internal Rate of Return, IRR. In Part I, pro forma financial statements (Balance Sheet (BS), Profit and Loses Statement (P &L) and Cash Budget (CB) are 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 included 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.

KEYWORDS

Free cash flow, cash flow to equity, cash flow to debt, project evaluation, firm valuation, investment valuation, Net Present Value NPV assumptions.

JEL Classification: D92, E22, E31, G31

1 This paper is based on chapter 6 of Velez-Pareja, Ignacio, Decisiones de inversión, Una aproximación al análisis de alternativas, CEJA, 1998. Available on line at http://www.javeriana.edu.co/decisiones/libro_on_line

INTRODUCTION

This is the first part of a paper where the construction of the free cash flow is studied. Usually a great deal of effort is devoted 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 Internal Rate of Return, IRR. In Part I, pro forma financial statements (Balance Sheet (BS), Profit and Loses Statement (P&L) and Cash Budget (CB) are presented. From the CB, the Free Cash Flow FCF, the Cash Flow to Equity CFE and the Cash Flow to Debt CFD, are derived. From the CB, the Free Cash Flow FCF, the Cash Flow to Equity CFE and the Cash Flow to Debt CFD, are derived. 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.

MODELS AND THEIR USE

Models simplify...