Question

Accounting for Financial Management: Free Cash Flow

The focus on traditional financial statements is -Select-marketaccountingreplacementItem 1 data rather than cash flow. However, cash flow is important to investors, managers, and stock analysts. Therefore, decision makers and security analysts need to modify financial statement data provided to them. An important modification is the concept of free cash flow (FCF). Many analysts regard FCF as being the single and most important number that can be developed from the income statements, even more important than net income. The equation for free cash flow is:

FCF = EBIT(1-T) - Net Investment in Operating Capital

-Select-NetFreeOperatingItem 2 cash flow is the cash flow actually available for payments to all investors (stockholders and debtholders) after the company has made investments in fixed assets, new products, and -Select-net operating working capitalnet working capitallong-term debtItem 3 . A negative FCF means that the company does not have sufficient -Select-externalinternalItem 4 funds to finance its investments in fixed assets and working capital, and that it will have to raise new money in the -Select-spotcapitalexchangeItem 5 markets to pay for these investments. Negative FCF is not always bad. If FCF is negative because after-tax operating income is negative this is bad, because the company is probably experiencing operating problems. Exceptions to this might be startup companies, companies incurring significant expenses to launch a new product line, and high-growth companies—with large capital investments.

Quantitative Problem: Rosnan Industries' 2018 and 2017 balance sheets and income statements are shown below.

Balance Sheets:
	2018	2017
Assets
Cash and equivalents	$100	$85
Accounts receivable	275	300
Inventories	375	250
Total current assets	$750	$635
Net plant and equipment	2,300	1,490
Total assets	$3,050	$2,125
Liabilities and Equity
Accounts payable	$150	$85
Accruals	75	50
Notes payable	150	75
Total current liabilities	$375	$210
Long-term debt	450	290
Total liabilities	$825	$500
Common stock	1,225	1,225
Retained earnings	1,000	400
Total common equity	$2,225	$1,625
Total liabilities and equity	$3,050	$2,125

Income Statements:
	2018	2017
Sales	$2,200	$1,300
Operating costs excluding depreciation	1,250	1,000
EBITDA	$950	$300
Depreciation and amortization	100	75
EBIT	$850	$225
Interest	62	45
EBT	$788	$180
Taxes (40%)	315	72
Net income	$473	$108
Dividends paid	$53	$48
Addition to retained earnings	$600	$60
Shares outstanding	100	100
Price	$25.00	$22.50
WACC	10.00%

The balance in the firm's cash and equivalents account is needed for operations and is not considered "excess" cash.

Using the financial statements given above, what is Rosnan's 2018 free cash flow (FCF)? Cash outflow, if any, should be indicated by a minus sign. Round your answer to the nearest dollar.

Answer 1

Net operating working capital = Current asstes - (current liabilities - Notes payable)
Net operating working capital 2017 = 635 - ((210 - 75) =	500
Net operating working capital 2018 = 750 - (375 - 150) =	525
Change in net operating working capital = 525 -500 = 25	25
Capital expenditure = Net fixed assets in 2018 + Depreciation for 2018 - Net fixed assets in 2017
Capital expenditure = = 2,300 + 100 - 1,490 =	910
Free cash flow = EBIT x (1-t) + Depreciation - capital expenditure - change in net operating working capital
Free Cash Flow =  850 x  (1 - 0.40) + 100 - 910 - 25	-325
Free Cash Flow =	-325