Free Cash Flow

Free cash flow (FCF), as used in a DCF valuation, is most accurately described as:

1. A.Net income reported on the income statementWrong. Net income includes non-cash charges and does not reflect capital expenditure needs the way FCF does.
2. B.Cash generated from operations after deducting the capital expenditures needed to sustain and grow the businessCorrect. This is the standard definition of free cash flow used in a DCF.
3. C.Total revenue less cost of goods soldWrong. That describes gross profit, not free cash flow.
4. D.The cash balance shown on the balance sheet at year-endWrong. A cash balance is a stock (point-in-time) figure, not a flow of cash generated during the period.

Why: Free cash flow represents the cash a business generates from operations after accounting for the capital expenditures needed to sustain and grow the business — the cash actually available to all capital providers.

Halworth Systems' final projected free cash flow is $50 million, expected to grow at a 3% terminal growth rate forever thereafter. Using a 9.2% WACC, what is the terminal value (using the Gordon growth / perpetuity growth model)?

1. A.$806.5 millionWrong. This uses $50M directly instead of growing it by (1 + g) first ($50M ÷ 0.062).
2. B.$830.6 millionCorrect. $50M × 1.03 ÷ 0.062 ≈ $830.6 million.
3. C.$1,612.9 millionWrong. This divides by (WACC − g) using a WACC or growth rate different from the ones given.
4. D.$538.6 millionWrong. This does not correctly apply the perpetuity growth formula to the given inputs.

Why: Terminal Value = Final Year FCF × (1 + g) ÷ (WACC − g) = $50M × 1.03 ÷ (0.092 − 0.03) = $51.5M ÷ 0.062 ≈ $830.6 million.

A simplified two-year DCF for fictional Halworth Systems has: Year 1 FCF of $40 million with present value of $36.6 million, and Year 2 FCF of $50 million with present value of $41.9 million. The present value of the terminal value (computed separately) is $658 million. What is the implied enterprise value?

1. A.$78.5 millionWrong. This sums only the two explicit-period present values and omits the terminal value entirely.
2. B.$658 millionWrong. This is only the present value of the terminal value, omitting the explicit-period cash flows.
3. C.$736.5 millionCorrect. $36.6M + $41.9M + $658M = $736.5 million.
4. D.$90 millionWrong. This sums the undiscounted Year 1 and Year 2 FCF figures, ignoring both discounting and the terminal value.

Why: Implied EV = sum of the present values of all explicit-period free cash flows plus the present value of the terminal value = $36.6M + $41.9M + $658M = $736.5 million.