Free cash flow — what to actually discount

Free cash flow is the number you discount. Get this wrong and nothing else in the DCF matters. The two definitions you will meet are FCFF — free cash flow to the firm, the cash available to all capital providers (both equity and debt) — and FCFE — free cash flow to equity, the cash available to shareholders alone after debt has been served. FCFF is more common in DCF practice because it side-steps capital-structure assumptions until the discount rate, leaving the analyst free to model the underlying business without simultaneously committing to a financing structure.

The FCFF bridge in formula form

  FCFF  =  EBIT  ×  ( 1 − t )   +   D&A   −   Capex   −   ΔNWC
        =  NOPAT  +  D&A  −  Capex  −  ΔNWC

Variable glossary — every line item explained

• FCFF — free cash flow to the firm, the cash the operating business generates that is available to pay all capital providers (debt-holders and equity-holders) collectively. Expressed in currency units per period. This is the number you discount at WACC to produce enterprise value.
• EBIT — earnings before interest and tax. Operating income, before financing decisions. Comes directly from the income statement and is the right starting point because it isolates the operating business from how it happens to be financed. Reading order: Revenue → minus COGS → minus operating expenses → equals EBIT.
• t — the marginal corporate tax rate, expressed as a decimal. The rate that applies to the next dollar of taxable income (Kenyan resident corporates: 30%, US federal corporate: 21% plus state). Use marginal rate, not effective rate, because we are projecting forward — the effective rate is contaminated by past one-offs.
• (1 − t) — the tax-adjustment factor that converts pre-tax EBIT into the after-tax operating profit NOPAT. Captures that the government takes a share of operating profit before any cash reaches capital providers.
• NOPAT — net operating profit after tax. EBIT × (1 − t). The hypothetical earnings the company would report if it carried zero debt and therefore zero interest expense. The cleanest measure of the operating business's profitability.
• D&A — depreciation and amortisation. Non-cash expenses that reduced EBIT but did not actually consume cash this period (the cash left the business when the asset was bought, captured separately in the Capex line). Added back to NOPAT to convert accounting profit into cash.
• Capex — capital expenditure during the period, in currency units. Cash actually spent on property, plant, equipment, intangibles. Includes both 'maintenance capex' (replacing depreciated assets to keep operations running) and 'growth capex' (expanding capacity). Pulled directly from the cash flow statement's investing-activities section.
• ΔNWC — change in net working capital during the period. Net working capital = current operating assets (receivables, inventory) minus current operating liabilities (payables, accruals). An increase in NWC means cash is tied up in financing customer receivables or inventory; a decrease means cash is being released. Pulled from the cash flow statement.

Worked FCFF example, line by line

Hypothetical mid-cap Kenyan manufacturer, FY26 forecast:

  Revenue                                  KES  10,000m
  − COGS                                       (6,400)m
  − Operating expenses                         (2,100)m
  ────────────────────────────────────────────────────
  EBIT                                          1,500m

  × (1 − t)  where t = 30%
  ────────────────────────────────────────────────────
  NOPAT                                         1,050m

  + D&A                                           400m
  − Capex                                        (550)m
  − ΔNWC (working capital grew 8% on 12% revenue growth)
         = 8% × 800m baseline working capital = 64m increase
                                                  (64)m
  ────────────────────────────────────────────────────
  FCFF                                          KES 836m

Reading: the firm generates KES 836m of cash available for all capital
providers in FY26. At a 14.84% WACC and the explicit-forecast / terminal-value
treatment of subsequent modules, this number drives the enterprise value.

Why net income is the wrong number to discount

Net income is contaminated by capital structure: it has been reduced by interest expense, which is one of the things WACC is already supposed to price. Discounting net income at WACC double-counts the cost of debt. EBITDA is the wrong starting point because it ignores capex — a real cash outflow even though depreciation is non-cash. NOPAT (EBIT after marginal tax) is the right starting point because it isolates the operating result before financing decisions, and FCFF then corrects NOPAT to a cash measure by adding back D&A and subtracting Capex and ΔNWC.

Why depreciation is added back

Depreciation reduces taxable income — it shields cash from tax — but it is not itself a cash outflow. The cash already left the business when the asset was purchased (that's the Capex line). Adding D&A back preserves the tax shield without double-counting the cash impact. The combination of subtracting Capex and adding back D&A says, in effect: 'the actual cash spent on long-life assets is Capex, not D&A; D&A was just an accounting allocation for tax purposes'.

Working capital — the line that catches everyone

An increase in working capital (more receivables, more inventory) consumes cash. A decrease releases cash. Most junior analysts forget that a fast-growing business will see working capital balloon proportional to revenue, and that this absorption consumes a substantial fraction of the operating cash flow that appears strong on the income statement. The cash conversion cycle from the accounting course shows up here as the forecast input: how many days of revenue sit in receivables, in inventory, in payables, and how that scales with growth.