Free Cash Flow

PBIT x (1-Tax %)

X

Interest is not deducted as this is the free cash flows to both debt and equity holders.

Adjustment for non-cash items

X

Depreciation should be added back.

Adjustment for working capital

X

Deduct cash flows when there is an increase in working capital; add back cash flows when there is a decrease in working capital.

Investment activities

X

Deduct cash flows when business makes capital investments.

Free cash flow to firm

X

PBIT – Interest

X

This arrives at Profit Before Tax (PBT)

• Tax expenses

PBT x Tax rate%

= Profit after tax

Adjustment for non-cash items

X

Depreciation should be added back.

Adjustment for working capital

X

Deduct cash flows when there is an increase in working capital; add back cash flows when there is a decrease in working capital.

Investment activities

X

Deduct cash flows when business makes capital investments.

Net debt repayments

(Debt borrowings – Debt repayment)

x/(x)

• Add when debt borrowings proceeds > debt repayment;

• Subtract when debt borrowings proceeds < debt repayment.

Free cash flow to equity

X

Free Cash Flow to Firm

• Interest net of tax

Net debt repayments

(Debt borrowings – Debt repayment)

x/(x)

• Add when debt borrowings proceeds > debt repayment;

• Subtract when debt borrowings proceeds < debt repayment.

Free cash flow to equity

X

Illustrative question

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

• During the year loan repayments are expected to amount to $20 million.
• Issue of new debt was $69m.
• Deprecation charge is $30 million and capital expenditure is $10 million.
• Norman ltd bought $3m inventory during the year.
• Norman Ltd had 100m shares in issue and Dividend per share is $0.03/share.

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.

Comment:

1: FCF to firm:

2: FCF to equity:

Method 1:

Method 2:

3: Dividend cover = FCFTE

Dividend paid

= 90

100m x 0.03

= 30 times

Exam standard question - Lirio Co (Dividend capacity)

Lirio Co is an engineering company which is involved in projects around the world. It has been growing steadily for several years and has maintained a stable dividend growth policy for a number of years now. The board of directors (BoD) is considering bidding for a large project which requires a substantial investment of $40 million. It can be assumed that the date today is 1 March 2016. The BoD is proposing that Lirio Co should not raise the finance for the project through additional debt or equity.

Instead, it proposes that the required finance is obtained from a combination of funds received from the sale of its equity investment in a European company and from cash flows generated from its normal business activity in the coming two years. As a result, Lirio Co’s current capital structure of 80 million $1 equity shares and $70 million 5% bonds is not expected to change in the foreseeable future.

The BoD has asked the company’s treasury department to prepare a discussion paper on the implications of this proposal. The following information on Lirio Co has been provided to assist in the preparation of the discussion paper.

Expected income and cash flow commitments prior to undertaking the large project for the year to the end of February 2017:

Lirio Co’s sales revenue is forecast to grow by 8% next year from its current level of $300 million, and the operating profit margin on this is expected to be 15%. It is expected that Lirio Co will have the following capital investment requirements for the coming year, before the impact of the large project is considered:

1. A $0·10 investment in working capital for every $1 increase in sales revenue;
2. An investment equivalent to the amount of depreciation to keep its non-current asset base at the present productive capacity. The current depreciation charge already included in the operating profit margin is 25% of the non-current assets of $50 million;
3. A $0·20 investment in additional non-current assets for every $1 increase in sales revenue;
4. $8 million additional investment in other small projects.

In addition to the above sales revenue and profits, Lirio Co has one overseas subsidiary – Pontac Co, from which it receives dividends of 80% on profits. Pontac Co produces a specialist tool which it sells locally for $60 each. It is expected that it will produce and sell 400,000 units of this specialist tool next year. Each tool will incur variable costs of $36 per unit and total annual fixed costs of $4 million to produce and sell.

Lirio Co pays corporation tax at 25% and Pontac Co pays corporation tax at 20%. In addition to this, a withholding tax of 8% is deducted from any dividends remitted from Pontac Co. A bi-lateral tax treaty exists between the countries where Lirio Co is based and where Pontac Co is based. Therefore corporation tax is payable on profits made by subsidiary companies, but full credit is given for corporation tax already paid.

It can be assumed that receipts from Pontac Co are in $ equivalent amounts and exchange rate fluctuations on these can be ignored.

Required:

Estimates Lirio Co’s dividend capacity as at 28 February 2017, prior to investing in the large project; (9 marks)

Comment:

Expected dividend capacity prior to large project investment:

Appendix 1.1: Dividend remittances expected from Pontac Co:

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