CHAPTER 9

FREE CASH FLOW MODEL AND ANALYSIS

LEARNING OBJECTIVES
1. The free cash flow valuation model.
2. The difference between free cash flow and GAAP definitions of cash flow.
3. The definition of free cash flow equivalents and why they are included in the free cash flow model.
4. How to derive a free cash flow statement from a historical combined GAAP income statement and cash flow
model.
TRUE/FALSE QUESTIONS
1. Because a forecast is forward looking it is often a good !redictor of the future.
(moderate, L.O. 1, Section 1, true)
". Although the free cash flow breakdown differs from the GAAP cash flow categories the net cash flow is
e#actly the same.
(moderate, L.O. 2, Section 2, true)
$. %et cash flow can be defined as the change in cash that occurs over a !eriod for a firm.
(moderate, L.O. 2, Section 2, true)
&. 'ertain noncash transactions that are not included in the GAAP income statement but are included in the
GAAP statement of cash flows are called free cash flow equivalents.
(moderate, L.O. 3, Section 2, false)
(. Adding GAAP cash flow from o!erations and GAAP cash flow from investing is a good starting !oint to
derive free cash flow.
(difficult, L.O. 3, Section 2, true)
). *hen !re!aring a free cash flow statement any cash flow resulting from an item such as a nono!erating
net asset must be moved into the free cash flow section of the statement.
(moderate, L.O. 4, Section 3, false)
+. Published balance sheets !re!ared under GAAP !rovide sufficient detail to create an accurate cash flow
statement.
(difficult, L.O. 4, Section 3, false)
,. -t is not necessary to understand how GAAP treats the firm.s transactions when !re!aring the free cash
flow statement.
(moderate, L.O. 4, Section 3, false)
/. 0ree cash flow ad1ustments can be made without a thorough understanding of GAAP since this statement is
not !re!ared under GAAP.
(moderate, L.O. 4, Section 3, false)
12. The analyst must know the firm.s federal and state income ta# rates to determine the amounts of ta# effects
on various items in the free cash flow statement.
(moderate, L.O. 4, Section 3, true)
11. The analyst double3checks that no items have been missed in the conversion of the GAAP cash flow
statement to the free cash flow statement by confirming that the total net change in cash is the same for
both statements.
()
(moderate, L.O. 4, Section 3, true)
1". 4nlike changes in interest !ayable the amorti5ation of bond discount or !remium is a difference between
interest e#!ense recogni5ed and cash !aid.
(difficult, L.O. 4, Section 3, false)
1$. Any change in the !rinci!al amount of debt during the year that is not e#!lained by issuances or
re!ayments is due to amorti5ation.
(moderate, L.O. 4, Section 3, true)
1&. -f there is essentially no difference between ca!itali5ed interest for financial re!orting and for ta# there is
no ta# effect necessary in making this ad1ustment in the free cash flow statement.
(moderate, L.O. 4, Section 3, true)
1(. *hen a firm has long3term construction contracts the amount of interest it may ca!itali5e de!ends on the
total dollar value of the contracts for the time !eriod.
(moderate, L.O. 4, Section 3, false)
MULTIPLE CHOICE QUESTIONS
1). The free cash flow model values the free cash flows stream of a firm. The value of other nonequity
com!onents is estimated by6
a. discounting a forecast of the firm.s e#!ected free cash flow for the nonequity com!onents
b. adding the value of core o!erations and subtracting the value of debt and other ca!ital claims
c. direct observation of market values or estimating fair values in other ways
d. adding the value of debt and other ca!ital claims minus the value of core o!erations
(moderate, L.O. 1, Section 1, c)
1+. To be able to use historical ratios for forecasting they must be calculated in e#actly the same way as the
ratios used to forecast free cash flow. The a!!ro!riate historical ratios cannot be calculated directly from
GAAP financial statements because6
a. GAAP requires the use of accrual accounting
b. these ratios include the effects of transactions that are not related to core o!erations
c. these ratios do not include the effects of transactions related to core o!erations
d. GAAP se!arates free cash flows from other cash flows
(moderate, L.O. 1, Section 1, b)
1,. The GAAP income statement and statement of cash flows differ from the free cash flow statement6
a. because GAAP categori5es cash flows in a different way than does the free cash flow statement
b. because the net cash flow from the GAAP cash flow statement is different than the net cash flow from
the free cash flow statement
c. GAAP does not re!ort in the income statement or statement of cash flows certain noncash transactions
that are included in the free cash flow statement
d. Answers a and c are both correct.
(difficult, L.O. 2, Section 2, d)
(+
1/. 7ne difference between GAAP financial statements and the free cash flow statement is that the free cash
flow statement includes free cash flow equivalents. These are transactions that6
a. have a com!onent relating to the firm.s o!erations not found in the GAAP financial statements
b. have one com!onent relating to the firm.s o!erations and a second relating to another element of the
economic balance sheet such as a com!onent of ca!ital
c. are essentially only one transaction that is shown on the free cash flow statement
d. %one of the above answers are correct.
(moderate, L.O. 3, Section 2, b)
"2. To create a free cash flow statement from GAAP information the analyst should6
a. reorgani5e the line items in the combined GAAP income and cash flow statements into the categories of
free cash flow nono!erating cash flow and ca!ital cash flow
b. discount the line items in the combined GAAP income and cash flow statements to their !resent values
c. convert GAAP cash flow from o!erations to free cash flow by ad1usting the com!onents of debt and
other ca!ital elements out of the GAAP cash flow from o!erations
d. convert GAAP cash flow from investing activities to free cash flow by ad1usting the cash flows to their
net !resent value based on the current cost of ca!ital for the firm
(moderate, L.O. 3, Section 2, a)
"1. 7n a free cash flow statement sales cost of sales and selling general and administrative e#!enses6
a. all relate to the firm.s core o!erations so these items are classified as !art of free cash flow
b. may not be identical to the items as !resented on a GAAP financial statement
c. are considered free cash flow equivalents
d. must be !resented using the GAAP standard of cash3basis accounting
(moderate, L.O. 3, Section 2, a)
"". -f a free cash flow equivalent such as the acquisition of a machine in e#change for debt is not shown in a
free cash flow statement6
a. the ca!ital e#!enditure will be understated by the amount that the machine was !aid for with debt
b. the cash balance from core o!erations will be understated and the analyst would have an erroneous
forecast
c. the addback for de!reciation e#!ense will be unaffected
d. the income ta# e#!ense will be unaffected
(moderate, L.O. 3, Section 2, a)
"$. To construct a free cash flow statement the analyst must6
a. only use and rely on the GAAP statement of cash flows when !re!aring the free cash flow statement
b. determine how an item was treated under GAAP and how it should be treated in the free cash flow
statement
c. reali5e that in reorgani5ing and ad1usting the total cash flow the net cash flow from free cash flow
statement will not equal the net cash flow from the GAAP cash flow statement
d. disregard the GAAP cash flow categories of o!erating investing and financing when !re!aring the free
cash flow statement
(difficult, L.O. 4, Section 3, b)
(,
"&. The free cash flow statement is !re!ared based on the firm.s GAAP statement of cash flows. This is the
suggested a!!roach to use because6
a. balance sheets !re!ared under GAAP require the use of accrual accounting
b. it is time3consuming although !ossible to re!roduce the cash flow statements found in most annual
re!orts from the accom!anying balance sheets
c. it is sim!ler to rearrange the items from the GAAP cash flow statement than to re3create a cash flow
statement from scratch
d. !ublished balance sheets generally !rovide much more detail than is necessary to create an accurate
cash flows statement
(difficult, L.O. 4, Section 3, c)
"(. *hen !re!aring a free cash flow statement an item such as interest e#!ense may require ad1ustment.
-nterest e#!ense will6
a. be ad1usted by moving it from free cash flow to ca!ital cash flow
b. be ad1usted by moving it from free cash flow to nono!erating cash flow
c. not be ad1usted as it is already a com!onent of free cash flow
d. be ad1usted by netting it against interest income and showing the result as a com!onent of free cash
flow
(difficult, L.O. 3, Section 4, a)
"). *hen !re!aring a free cash flow statement the income ta# effect from an item such as interest e#!ense
must be considered. The income ta# e#!ense related to interest e#!ense will6
a. not be ad1usted as income ta# e#!ense is considered an item of free cash flow
b. will be shown as a ca!ital cash flow ad1ustment
c. will be shown as a nono!erating cash flow ad1ustment
d. will be added to interest e#!ense and the new total shown as a nono!erating cash flow ad1ustment
(difficult, L.O. 4, Section 3, b)
"+. -n converting the GAAP cash flow statement to a free cash flow statement the analyst must6
a. remove the free cash flow from any cash flows related to nono!erating assets
b. remove the free cash flow between the firm and any ca!ital claimants
c. record any free cash flow equivalents
d. All of the answers above are correct.
(easy, L.O. 4, Section 3, d)
",. The ad1ustments made to convert a GAAP cash flow statement to a free cash flow statement can be
grou!ed into various categories. An ad1ustment made for the income ta# effect of interest income the firm
received can be !laced in the category of6
a. free cash flow equivalents
b. interest e#!ense and related amounts
c. nono!erating cash flows
d. em!loyee stock o!tions
(moderate, L.O. 4, Section 3, c)
"/. 8istributions from a 1oint venture6
a. is a com!onent of free cash flow on the free cash flow statement
b. will be moved from free cash flow to ca!ital cash flow
c. will be moved from free cash flow to nono!erating cash flow
d. will be e#cluded from the free cash flow statement as the distributions a!!ly to an entity outside of the
firm itself
(difficult, L.O. 4, Section 3, c)
(/
$2. The sale or maturity of an available3for3sale investment is shown on the free cash flow statement as a6
a. free cash flow item
b. nono!erating cash flow item
c. ca!ital cash flow item
d. ca!ital cash flow item net of the income ta# effect on the cash flow from the investment itself
(moderate, L.O. 4, Section 3, b)
$1. 9inority interest is the ca!ital that a firm obtains from minority shareholders in consolidated subsidiaries.
The change in the firm.s minority interest6
a. is reclassified to the ca!ital cash flow section because it relates to how the firm is financed not to its
core o!erations
b. is reclassified to the nono!erating cash flow section because it relates to other investments of the firm
not to its core o!erations
c. is not reclassified on the free cash flow statement
d. is not shown on the free cash flow statement as it relates to activities outside of the firm itself
(difficult, L.O. 4, Section 3, a)
$". *hen an analyst !re!aring a free cash flow statement encounters an unusual transaction the best course of
action is to6
a. determine how the transaction is treated under GAAP
b. determine how it should be treated in the free cash flow statement
c. ad1ust the transaction from GAAP to free cash flow
d. All of the above answers are correct.
(easy, L.O. 4, Section 3, d)
$$. -n a free cash flow statement the amorti5ation of bond discount is6
a. not ad1usted since it is a com!onent of free cash flow
b. ad1usted by moving it from the free cash flow section to the ca!ital cash flow section of the statement:
however the after3ta# interest will remain a com!onent of free cash flow
c. ad1usted by moving it from the free cash flow section to the nono!erating cash flow section of the
statement
d. ad1usted by moving it from the free cash flow section to the ca!ital cash flow section of the statement
along with the after3ta# interest
(moderate, L.O. 4, Section 3, d)
$&. A firm has long3term construction !ro1ects. 4nder GAAP it may6
a. defer the entire amount of its interest !ayments until the com!letion of the construction !ro1ects
b. only e#!ense a !ortion of its interest !ayments
c. choose to e#!ense or ca!itali5e a !ortion of its interest !ayments
d. ca!itali5e a !ortion of its interest !ayments and charge the !ortion to a fi#ed asset account rather than
to interest e#!ense
(moderate, L.O. 4, Section 3, d)
$(. The amount of interest that a firm with long3term construction !ro1ects may ca!itali5e de!ends on6
a. if the ca!itali5ed interest is considered a free or ca!ital cash flow on the free cash flow statement
b. the total accumulated cost of the com!leted long3term construction !ro1ects for the accounting !eriod
c. the average construction in !rogress balance during the year times the firm.s average borrowing rate
not to e#ceed the total interest cost incurred during the !eriod
d. %one of the above answers are correct.
(difficult, L.O. 4, Section 3, c)
)2
ESSAYS
$). ;#!lain the differences between the GAAP and free cash flow statements.
<uggested solution6
There are two ma1or differences between the combined GAAP income and cash flow statements and the free
cash flow statement. 0irst GAAP categori5es cash flow differently than does the free cash flow statement.
<econd GAAP does not require the re!orting of certain noncash transactions that are included in the free
cash flow statement.
The GAAP statement of cash flows is divided into three categories of cash flow6 o!erating investing and
financing. These categories although required under GAAP are not a!!ro!riate for the free cash flow
statement because it must mirror the economic balance sheet. 0or !ur!oses of the free cash flow statement
cash flows are broken down into the categories of free cash flow nono!erating cash flow and ca!ital cash
flow. The net cash flow for a firm will be the same whether a GAAP cash flow or free cash flow statement
is !re!ared thus giving the analyst a way to double3check the re3categori5ation of items from the GAAP
statement to the free cash flow format.
The free cash flow statement contains certain noncash transactions that are not re!orted under GAAP. <uch
transactions are called free cash flow equivalents. 0ree cash flow equivalents have two com!onents one
!ertaining to a firm.s core o!erations and the other !ertaining to some other element of the economic
balance sheet which is usually a com!onent of ca!ital. 0or e#am!le the !urchase of machinery in
e#change for debt is a noncash transaction that is not re!orted on the GAAP cash flow statement. However
this transaction not re!orted under GAAP in the statement of cash flows would be shown as two se!arate
transactions in the free cash flow statement =since it affects the firm.s core o!erations as well as its ca!ital
!osition>.
(moderate, L.O. 2 & 3, Section 1)
$+. 8iscuss how a GAAP cash flow statement is converted into a free cash flow statement.
<uggested solution6
To !re!are a free cash flow statement the analyst begins with the GAAP income statement and statement
of cash flows. -tems found on the GAAP statements are reorgani5ed into the free cash flow statement under
the categories of free cash flow nono!erating cash flow and ca!ital cash flow. This reorgani5ation may
require certain items to be reclassified and?or ad1usted.
-tems such as sales cost of sales and selling and general and administrative e#!enses all relate to the firm.s
core o!erations so they will be classified as com!onents of free cash flow. 9arketable securities are
considered nono!erating items. An item such as interest e#!ense relates to the firm.s debt and would be
classified as ca!ital cash flow. The free cash flow statement will also identify free cash flow equivalents.
At the end of the !re!aration !rocess the total net cash flow from free cash flows nono!erating cash
flows and ca!ital cash flows will be equivalent to the total net cash flow found on the GAAP cash flow
statement. The free cash flow statement will follow the economic balance sheet for the firm and as such
will be useful in the valuation of the firm.
(moderate, L.O. 4, Section 2)
)1
$,. *hy does the analyst use the GAAP cash flow statement in constructing the free cash flow statement@
<uggested solution6
There are two reasons why an analyst will use the GAAP cash flow statement as a basis for constructing
the free cash flow statement rather than begin with the firm.s balance sheets. 0irst substantial analysis has
taken !lace in !re!aring the firm.s financial statements under GAAP. -t would be a du!lication of effort and
a waste of time to reanaly5e the changes in each of the firm.s balance sheet accounts which has already
been done to !re!are the GAAP cash flow statement. Also the analyst can be assured that the statement has
been !re!ared under and com!lies with GAAP and therefore the items listed on the statement can be relied
u!on. -t is sim!ler and more efficient for the analyst to use the GAAP cash flow statement as a foundation
in building the free cash flow statement.
<econd the balance sheets available to the !ublic do not !rovide sufficient detail to create an accurate cash
flow statement. The accountants who !re!ared a firm.s GAAP cash flow statement had considerable more
detailed information available to aid in its creation than what is found in the firm.s annual re!ort. -t may
well be im!ossible to re3create the GAAP cash flow statement from the annual re!ort.s balance sheets for
this reason. Again it would be inefficient and ineffective to start with GAAP balance sheets as o!!osed to
using the GAAP cash flow statement as the !oint of beginning in the creation of the free cash flow
statement.
(moderate, L.O. 4, Section 3)
)"