Free cash flow
Read firstWorking capital. Valuation without accounting is memorization.
A discounts cash flows. Which cash flows is the entire question, and getting it wrong does not produce an error message. It produces a confident number that is too high.
Free cash flow to the firm
FCFF, the unlevered version
Notice what is missing. Interest does not appear. That is deliberate, and it is the thing to be able to explain in one sentence: is the cash available to everyone who funded the company, and paying the lenders is a use of that cash rather than a reduction of it.
The tax line is the subtle part. is taxed at the full rate as if there were no interest deduction, which overstates the cash tax bill for a levered company. That is not an oversight. The benefit of the deduction shows up in , where the is multiplied by one minus the tax rate. Take it in both places and you have counted the tax shield twice.
On the running example
| FY2025 | |
|---|---|
| Operating income (EBIT) | 5,117 |
| Tax at 22.3% | negative 1,140 |
| NOPAT | 3,977 |
| Plus D&A | 3,134 |
| Less capex | negative 3,727 |
| Less increase in working capitalRoughly flat this year, so it is left at zero rather than guessed | 0 |
| Free cash flow to the firm | 3,384 |
Derived from Target Corporation's Form 10-K for Fiscal 2025. NOPAT uses the effective tax rate of 22.3%, computed as tax expense over pretax income.
$3,384M of unlevered , against $2,835M of the simpler operating cash flow less . The two differ because the operating cash flow line is after interest and after actual cash taxes, and FCFF is before interest and at the effective rate. Neither is wrong. They answer different questions and they discount at different rates.
Free cash flow to equity
FCFE, the levered version
| Discount at | Produces | |
|---|---|---|
| Free cash flow to the firm | WACC | Enterprise value |
| Free cash flow to equity | Cost of equity | Equity value |
| Dividends | Cost of equity | Equity value |
Test yourself
01Why does FCFF start at EBIT rather than net income?
Because FCFF belongs to lenders and shareholders together, and net income is already after paying the lenders. Starting at EBIT and taxing it as if the company had no debt produces the cash the operations generate regardless of how they are funded. The tax benefit of the interest is not lost, it moves into WACC, where it appears as the after-tax cost of debt.
02You have levered free cash flow and a WACC. What do you do?
Not discount one by the other. Levered free cash flow belongs to shareholders, so it discounts at the cost of equity and produces equity value directly with no bridge. WACC discounts unlevered cash flow to enterprise value. Mixing them double counts the benefit of debt and produces a number that is too high, and it is the single most common valuation error in published models.
03A company's free cash flow jumped 40% with flat revenue. What do you check first?
Working capital and capex, in that order. A one-time working capital release, from stretching payables or clearing inventory, flatters cash once and cannot repeat. Capex cut below depreciation flatters it for as long as the assets last. Both look identical to genuine improvement in a single year, and neither survives three.
A tutor that knows this lesson. It asks before it explains, and it will not tell you what to do with your own money.
Every figure in this lesson that names a company comes from Target Corporation's Form 10-K for Fiscal 2025, the year ended 2026-01-31, filed 2026-03-11. Educational material, not investment advice.