A:

Free cash flow to the firm, or FCFF, measures money and time through the use of short- and long-term assets and earnings before interest, taxes, depreciation and amortization (EBITDA) in its calculations. FCFF itself is used to measure the risk an investor faces in getting a return on his investment.

FCFF to the firm measures the cash a company has available to pay investors after the company pays its cost of doing business and invests in short- and long-term assets such as inventory and equipment, respectively. Investors include both stockholders and bondholders. The following equations can be used to calculate FCFF:

Free cash flow to the firm = (net income) + (noncash charges) + (interest) x (1-tax rate) - (investments in long-term assets) - (investments in working capital)

Free cash flow to the firm = (cash flow from operations) + (interest) x (1-tax rate) - (investments in long-term assets)

Free cash flow to the firm = (earnings before interest and taxes) x (1-tax rate) + (depreciation) - (investments in long-term assets) - (investments in working capital)

Free cash flow to the firm = (earnings before interest, taxes, depreciation and amortization) x (1-tax rate) + (depreciation) x (tax rate) - (investments in long-term assets) - (investments in working capital)

As you can see from the four equations above, FCFF uses both short- and long-term investments in its calculations. This helps capture the measurement of time. In addition, each component of the FCFF equations is over a specific time period, so it is possible to calculate the monthly, quarterly or yearly FCFF depending on the time frame the investor wants to use.

FCFF measures money through the use of financial information in each one of its components. All types of earnings, from net income to EBITDA, measure the money a company makes over the specified time period. All noncash charges including interest and depreciation are added back to capture the actual cash flow of the business. Since the money a company uses for investments cannot be paid out to investors in the form of cash, these are subtracted from the equation.

Although FCFF is a monetary measure of how much money is available to investors, it is a great indicator of risk. If the FCFF is low or negative, it could be a signal the investment is not safe because there is either a low return or no return. A high amount of FCFF could be a signal there is low risk and the investment is a good opportunity.

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