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  • Free cash flow to firm is cash flow from operations+ interest expense -cash flow from investing activities.
  • Free cash flow to equity is free cash flow-interest expense(net of tax)-net debt borrowing.
  • Once we have calculated the free cash flow to equity we can then establish the dividend cover based on free cash flow to equity. We have learnt how to calculate dividend cover where we take PAT/Dividend paid. But before PAT is profit and it’s subject to manipulation by management so we can use a cash flow approach to do this.

 
There are 2 ways to calculate free cash flow to equity: 

  1. Direct method:
  2. Indirect method:
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Direct method:

 
PATX

Adjustment for non cash itemX

Adjustment for changes in working capitalX

cash flow from investing activitiesX

Adjustment for net debt borrowingX

Free cash flow to equityX

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Indirect method:

 
Free cash flowX

interest paid(net of tax)-because in free cash flow we have subtracted the whole taxesX

Adjustment for net debt borrowingX

Free cash flow to equityX

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Free cash flow needs to be assessed not in a single period because sometimes company would spend money into expanding the business in the current year so the current year’s free cash flow would be low but it does benefit the company for the long term.
 
Example Human Ltd

 

The following statement of profit or loss relates to Human Ltd.

  $m
Sales 90
Cost of sales (30)
Gross profit 60
Operating expense (20)
PBIT 40
Interest (10)
PBT 30
Tax@20% (6)
PAT 24

 

During the year loan repayments are expected to amount to $20 million.

Issue of new debt is $69m.

Deprecation charge is $30 million and capital expenditure is $10 million.

Human ltd bought $3 inventory during the year.

Human Ltd ha 100m shares in issue and DPS is $0.03.

Required:

  1. calculate free cash flow to firm
  2. calculate free cash flow to equity
  3. calculate dividend cover using free cash flow to equity method.