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While valuing firms, free cash flow has to be calculated over a number of years. Hence, there is a good chance that the firm may change its financing policies during such a long period. It is for this reason that we need to consider what happens to the cash flows in the event financing policies were actually changed. Analysts usually consider the fact that the cost of operations of a firm will change over time. They do consider factors like inflation, increase in the cost of raw material, increase in wages and so on. However, as we have seen the effect of changes in financing policy are never considered. In this article, we will do the same.
So, the objective is to figure out what are the possible changes in financing policy that can actually happen. Then the next step is to figure out how the cash flow changes in the event of each of these policy changes.
Here are the changes which firms usually make to their financing policy:
Let’s first consider the case of effect on leverage and how it affects both measures of free cash flow i.e. cash flow to the firm and cash flow to equity.
Since we have considered the cases of share repurchase and share buybacks separately, the change in leverage can be zeroed down to one single factor i.e. the change in debt.
In the event of paying off a debt or raising new debt, there will be no effect on the free cash flow to the firm. This is because free cash flow to the firm considers the cash that will accrue to the firm as a whole and not to equity and debt holders separately.
However, the free cash flow to equity shareholders is affected when debt is paid off or raised.
When a firm uses additional cash to pay off debt now, it’s free cash flow to equity is reduced in the current year. However, this reduction is offset by an increase in free cash flow to equity in the forthcoming years since the debt has been paid off and does not have to be serviced.
In the event of the firm raising more debt, the exact opposite happens. The free cash flow to equity increases in the current year and falls down in the subsequent years.
Hence, if an analysts suspects that the firm is going to change its debt policy in the future, they must account for it while calculating free cash flow to equity.
The cases listed above as case number 2, 3 and 4 have been combined in this point. The reason for doing this is that all these cases work on the same logic.
Increase or decreases in dividends, share issues and share repurchases have absolutely no effect on the free cash flow to the firm or on the free cash flow to equity! Both these measures of cash flows are calculated from EBIDTA or from cash flow from operations.
EBIDTA appears before any financing effects on the balance sheet and cash flow from operations are calculated from the net income number. In either case, how the financing is done will have no effect.
This fact is often used by examiners to confuse students. Usually there will be information that is relevant and then one of the above points will be mentioned. Please remember that case numbers 2,3 and 4 have no effect on the free cash flows.
Hence, the only change that a firm can make to its financing policy that can affect the firm’s free cash flows is issuing more debt!
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