How to Calculate Free Cash Flow (FCF) Using EBIT(1–t) Approach – CFA-Level Explanation

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🧾 How to Calculate Free Cash Flow (FCF) Using EBIT(1–t) Approach – CFA-Level Explanation

📌 What Is Free Cash Flow?

Free Cash Flow (FCF) represents the cash a business generates after accounting for the reinvestment in working capital and fixed assets (CapEx). It’s a key indicator of a firm’s ability to create shareholder value.

This method calculates Unlevered Free Cash Flow, which ignores the effects of debt (interest payments), making it ideal for valuation purposes like DCF where capital structure neutrality is important.

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🔢 Formula: FCF from EBIT(1–t)

{FCF} = {EBIT}(1 - t) + {Depreciation & Amortization} - {Change in Working Capital} - {Capital Expenditure}

Let’s break it down line by line, as shown in your image:

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1. Revenue

While not directly used in the FCF formula, Revenue is the starting point in financial modeling. It's used to project future EBIT (Earnings Before Interest and Taxes) via margin assumptions.

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2. EBIT × (1 - t)

EBIT represents the operating profit before interest and taxes. To arrive at after-tax operating profit:

$$\text{EBIT}(1 - t) = \text{Operating Profit After Tax (NOPAT)}$$

• t = Tax rate (e.g., 25% or 0.25)

• This adjustment ensures we use the cash available to all capital providers (both debt and equity) after taxes.

Example: If EBIT = ₹1,000 Cr and tax rate = 25%,
EBIT(1–t) = ₹1,000 × (1 – 0.25) = ₹750 Cr

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3. Add: Depreciation & Amortization

These are non-cash expenses. While they reduce accounting profits, they do not affect actual cash flow. Therefore, they are added back to arrive at true cash generation.

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4. Less: Change in Working Capital

Changes in Net Working Capital (NWC) represent cash tied up or released in operating assets and liabilities:

• An increase in NWC (e.g., more inventory or receivables) means cash outflow

• A decrease in NWC means cash inflow

Formula:

$$\text{Change in NWC} = (CA_{t} - CL_{t}) - (CA_{t-1} - CL_{t-1})$$

where CA = Current Assets, CL = Current Liabilities

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5. Less: Capital Expenditures

CapEx represents cash spent to acquire or upgrade physical assets (like factories, machinery, technology, etc.). It's a real cash outflow and is deducted from EBIT(1–t).

CapEx can be found in the Cash Flow Statement under "Investing Activities."

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✅ Example Calculation

Particulars Amount (₹ Cr) EBIT ₹1,000 Tax Rate 25% EBIT(1 – t) ₹750 Add: Depreciation & Amortization ₹200 Less: Change in Working Capital ₹100 Less: Capital Expenditure ₹300 Free Cash Flow (FCF) ₹750 + ₹200 – ₹100 – ₹300 = ₹550 Cr
🧠 Why Use EBIT(1–t) for DCF?

This method gives Unlevered Free Cash Flow, independent of capital structure. It’s preferred in DCF valuation because:

• It allows the use of WACC (Weighted Average Cost of Capital) to discount cash flows.

• It reflects the cash available before interest payments, useful when comparing companies with different debt levels.

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🏁 Final Notes

• Always cross-check CapEx and working capital changes from the Cash Flow Statement and Balance Sheet, respectively.

• Use consistent time periods and ensure non-recurring items are adjusted out.

• The EBIT(1–t) approach is widely accepted in corporate finance and used by CFA charterholders for valuation modeling.

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