Question

In finding FCF, EBIT subtracts Depreciation then the FCF formula adds it back in. But then when I look at Capital Expenditures, Additions to property, plant, and equipment seems to include depreciation in that calculation also. I'm confused. How can depreciation be included in 3 areas of the FCF formula?. Thank you.

Answer 1

1]	FCF = OCF-Capital expenditure-Change in NWC
	The FCF is, thus, only deals with actual cash flows. Depreciation
	is a non cash expenditure, but, its tax shield is to be taken into account.
2]	OCF [Operating cash flow] = EBIT*(1-t)+Depreciation
	While calculating EBIT, depreciation is to be deducted, because, tax is
	to be calculated on the income after providing for depreciation expense.
	Once tax is calculated, then depreciation is to be added as it is a non cash
	item.
	Another way to arrive at OCF is to find out EBITDA [Earnings before
	interest, taxes, depreciation and amortization].
	Apply tax rate on EBITDA and then substract the tax.
	It is EBITDA*(1-t).
	To the above figure, we have to add the tax shield on depreciation, which,
	is Depreciation*t.
	Now, OCF = EBITDA*(1-t)+Depreciation*t
3]	Capital expenditure should be the amount spent on buying fixed assets.
	If the gross fixed assets are available, the capital expenditure is
	Ending gross fixed assets-Beginning gross fixed assets after adjusting for
	gross value of fixed assets sold during the year.
	If gross fixed asset values are not available, the capitlal expenditure has
	to be calculated from the net fixed assets, which is after depreciation
	written off during the year. Hence, adjustment is required for depreciation
	expense for the year. Hence, capital expenditure =
	Ending net fixed assets-Beginning net fixed assets, after adding back
	depreciation provided during the year.
	Please note that EBIT*(-t) is adjusted for depreciation to give effect to
	the tax shield on depreciation.
	Hence, depreciation is first subtracted from revenues to get EBIT. After
	calculating tax on EBIT, depreciation has to be added back as it is not a
	cash expenditure, and we require only cash flows.
	Lastly to get net capital expenditure, depreciation is to be added to
	beginning NFA to eliminate the effect of non cash depreciation.