Forecasting Free Cash Flows

Forecast Free Cash Flows

We now have the data needed to forecast Ideko’s free cash flows over the next five years. Ideko’s forecast earnings are available from the income statement (Ideko - Forecast Earnings) as are its depreciation and interest expenses. Capital expenditures are available from the Business Plan (Ideko - Capital Expenditure Plan), and changes in net working capital can be found here (Ideko - Forecast NWC). We combine these items to estimate the free cash flows in the spreadsheet, as shown below:


Unlevered Net Income

To compute Ideko’s free cash flow, which excludes cash flows associated with leverage, we first adjust net income by adding back the after-tax interest payments associated with the net debt in its capital structure:

\[\begin{align*} & \text{After-Tax Interest Expense} = \text{1 - Tax Rate} * (\text{Interest on Debt} - \text{Interest on excess Cash}) \end{align*}\]

Because Ideko has no excess cash, its after-tax interest expense in 20X6 is (1 - 35%) * 6.8 = $4.42 million, providing unlevered net income of 5.193 + 4.42 = $9.613 million. You could also compute the unlevered net income by starting with EBIT and deducting taxes. In 20X6, for example, EBIT is forecasted as $14.788 million, which amounts to 14.788 * (1 - 35%) = $9.613 million after taxes.

Free Cash Flow to Firm

To compute Ideko’s free cash flow from its unlevered net income, we add back depreciation (which is not a cash expense), and deduct Ideko’s increases in net working capital and capital expenditures.

The free cash flow shows the cash the firm will generate for its investors, both debt and equity holders. While Ideko will generate substantial free cash flow over the next five years, the level of free cash flow varies substantially from year to year. It is highest in 20X6 (due mostly to the large reduction in working capital) and is forecasted to be negative in 20X8 (when the plant expansion will begin).

Free Cash Flow to Equity

To determine the free cash flow to equity, we first add Ideko’s net borrowing (that is, increases to net debt):

\[\begin{align*} & \text{Net Borrowing in Year } t = \text{Net Debt in Year } t - (\text{Net Debt in Year } (t - 1) \end{align*}\]

Ideko will borrow in 20X8 and 20X9 as part of its expansion. We then deduct the after-tax interest payments that were added in line before above.

As shown in the last line, during the next five years Ideko is expected to generate a positive free cash flow to equity, which will be used to pay dividends to Kleiner Perkins. The free cash flow to equity will be highest in 20X6; by 20Y0, Kleiner Perkins will recoup a significant fraction of its initial investment.