Accounting statements represent a company\'s earnings, but this is not the real
ID: 2780288 • Letter: A
Question
Accounting statements represent a company's earnings, but this is not the real cash that a company generates. Earnings data can be manipulated and can be deceiving. Thus, corporate decision makers and security analysts focus on the free cash flow that a firm generates to analyze the company's real cash position. Which of the following statements best describes free cash flow? The cash flow available for distribution to all investors after the company has made all investments in fixed assets and working capital necessary to sustain a firm's ongoing operations O The excess cash generated by revenues less all operating expenses Suppose you are the only owner of a chain of coffee shops near universities. Your current cafés are doing well, but you are interested in starting a fine-dining restaurant. You decide to use the cash generated from your existing business to enter into a new business. Your accountant provides you with the following data on your current financial performance: Financial update as of June 15 Your existing business generates $75,000 in EBIT. The corporate tax rate applicable to your business is 35% The depreciation expense reported in the financial statements is $14,286 You don't need to spend any money for new equipment in your existing cafés; however, you do need $11,250 of additional cash. You also need to purchase $6,000 in additional supplies-such as cloth tableclothes and napkins, and more formal tableware-on credit. It is also estimated that your accruals, including taxes and wages payable, will increase by $3,750 Based on your evaluation you have n free cash flow.Explanation / Answer
The first statement is correct.
FCF = EBIT x (1 - tax) + Depreciation - FCInv - WCInv
= 75,000 x (1 - 35%) + 14,286 - 0 - (6,000 - 3,750)
= 60,786
Acquiring operating assets is not a use of free cash flows, as it would have been already accounted in FCF calculation.