Free Cash Flow vs. Cash Flows to Shareholders

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The recommended method for capital budgeting is to discount free cash flows. In computing free cash flow, interest is not yet deducted in the income calculation. Free cash flow is cash flow available to make (after-tax) interest payments, repayments of principal, and payments to shareholders. This spreadsheet shows that the NPV of free cash flow (discounted at the weighted average cost of capital) equals the NPV of cash flows to lenders (after-tax interest plus repayment of principal less receipt of principal) discounted at the after-tax cost of debt plus the NPV of cash flows to shareholders discounted at the cost of equity. Usually, the NPV of cash flows to lenders is zero, so the NPV of cash flows to shareholders can be computed by discounting free cash flow. However, if the interest rate is below market, then the NPV of cash flows to lenders is negative. This has positive value for shareholders and should be added to the NPV of free cash flow.
Source: Professor Kerry Back (Washington University in St. Louis)
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Subjects: Finance, Spreadsheets
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