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1.5 Free Cash Flows

After we have constructed pro forma, or projected, financial statements for the project that we are trying to value, we can calculate the expected future cash flows, E(CF1), E(CF2), ... needed for Equation 1. To illustrate this point, Figure 1.4 presents a projected balance sheet. The cash flows that need to be input into Equation 1 are known as free cash flows and are depicted in Figure 1.4 by the arrow labeled Free Cash Flow. This diagram is conveying a picture of what precisely we are determining when we calculate free cash flows for a present value computation. For a typical project at a typical company, the left-hand side of the balance sheet represents the “business,” while the right-hand side represents the financing. Therefore, the left-hand side of the balance sheet generates the revenues and nonfinancing costs associated with the project.5 These cash flows flow from the left-hand side to the right-hand side. The right-hand side can be broken down crudely into debt and equity. Therefore, the cash flows that are being generated by the business are flowing to those entities that are financing the business: the debt holders and the equity holders. If we want to do a valuation from the perspective of all financial claimants (both debt and equity holders), the cash flows used in Equation 1 are the free cash flows. This would produce a value for the entire left-hand side of the balance sheet. Chapter 4, “Free Cash Flows,” covers this concept of free cash flows and goes into the detail about how to calculate free cash flows. The goal of Chapter 4 is to be able to produce all the numbers needed for the numerators in Equation 1 for any business project or company that one might want to value.


Figure 1.4 ABC Company projected balance sheet

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