Which of the following about Free Cash Flows (FCFs) is TRUE?
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A. B. C. D.Explanation
FCF = Cash flows from operations - Net capital expenditures required to maintain productive capacity - Dividends on preferred stock and common stock
(assuming a payout policy).
The correct answer is B. FCF = Cash from operations - outlays for maintenance of current capacity - dividends declared.
Free Cash Flow (FCF) is a measure of the cash generated by a company's operations that is available for distribution to all providers of capital, including equity shareholders and debt holders. It represents the cash flow that remains after the company has made necessary investments in its operations and has met its financial obligations.
To calculate Free Cash Flow, you start with the Cash from Operations, which represents the cash generated by the company's core business activities. This includes cash received from customers, cash paid to suppliers, and cash paid to employees. It is a measure of the company's ability to generate cash through its regular operations.
From the Cash from Operations, you deduct certain outlays to arrive at the Free Cash Flow. These outlays include:
Outlays for Maintenance of Current Capacity: These are the capital expenditures required to maintain the company's existing productive capacity. It includes spending on repairs, replacements, and upgrades necessary to keep the current operations running smoothly. These expenses ensure that the company's assets are maintained and can continue to generate cash flow. Subtracting these outlays ensures that the FCF reflects the cash available after maintaining the current productive capacity.
Dividends Declared: Dividends are the distribution of profits to the shareholders of a company. They represent the portion of earnings that the company decides to distribute to its shareholders. Dividends declared reduce the cash available to reinvest in the business or to pay down debt. Subtracting dividends declared from the cash from operations reflects the cash available after distributing profits to shareholders.
By subtracting both the outlays for maintenance of current capacity and dividends declared from the cash from operations, we arrive at the Free Cash Flow (FCF). This measure represents the cash flow available to the company for other purposes, such as investing in new projects, reducing debt, or returning capital to shareholders through share repurchases.
Therefore, option B is the correct answer: FCF = Cash from operations - outlays for maintenance of current capacity - dividends declared.