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    Free Cash Flow

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    Explain the theory behind the free cash flow valuation approach. Why are the free cash flows value relevant to common equity shareholders when they are not cash flows to those shareholders, but rather are cash flows into the firm?

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    First let's start with a working definition of free cash flow as follows:

    In corporate finance, free cash flow (FCF) or free cash flow to firm (FCFF) is a way of looking at a business's cash flow to see what is available for distribution among all the securities holders of a corporate entity. This may be useful to parties such as equity holders, debt holders, preferred stock holders, convertible security holders, and so on when they want to see how much cash can be extracted from a company without causing issues to its operations.

    The free cash flow can be calculated in a number of different ways depending on audience and what accounting information is available. A common definition is to take the earnings before interest after taxes, add any depreciation & Amortization, and then subtract any changes in working capital and capital expenditure. Depending on the audience, a number of refinements and adjustments may also be made to try to eliminate distortions.

    The free cash may be different from the net income for a particular accounting period, as the free cash flow takes into account the consumption of capital goods and the increases required in working capital.

    Now let's examine why a firm holds cash. Cash is held for three basic reasons:

    * for operations - to conduct transactional types of business and, essentially, to pay the bills

    * for investing - to be in a position to take advantage of investment opportunities which may arise, including investing in themselves when necessary

    * for contingencies - for unforeseen events which need attention and which may not have been planned for.

    In addition, if we consider cash flow and profitability we note that the firm can gain access to available cash much quicker and more accurately ...

    Solution Summary

    A discussion relating the ability of a firm to create free cash flow and the resulting impacts on the firm.