Hi all,

I am facing a valuation problem.

On this financial statement,

Net Income = Operating Income – Reorganization Expense – Amortization of goodwill – Net Interest Expense – Performance Plan Expenses – Equity in net income in unconsolidated subsidiaries – Income taxes – Minority Interest.

I am also facing the following cash flow data:
(1) Deferred taxes; (2) Undistributed earnings in unconsolidated subsidiaries; (3) Minority Interest; (4) Change of net working capital; (5) Capital expenditures.

I know how to deal with (4) and (5). But I don’t know how to deal with (1), (2) and (3) when calculating the unlevered free cash flow, starting from the net income?

Also, do I remove the "net interest expense" and "deferred taxes" from "net income" and start from the resultant "net income" for calculate the unlevered free cash flow, since it should be "unlevered"?

Thanks for your help!

1. Deferred taxes is a non-cash item that has to be adjusted like it is another working capital item (e.g inventory, AP, AR). If it goes up, then it is taxes you didn’t pay and cash goes up. If it goes down, then visa versa.

2. This is only for equity accounted entities. Cost accounted profits are only recognized when cash is received. Equity accounted is based on a net pro-rata basis. Net income therefore has to be reduced by the undistributed equity-accounted earnings (e.g. $20 in equity income means your FCF are $20 lower than the income statement).

3. Minority interests. This is money owned by a consolidated, but not 100% owned subsidiary. It is non-cash. Since this is a "negative" balance, the FCF is higher than net income because you still have the cash and haven’t really distributed it to minority holders.

B. Net Interest Expense includes a tax benefit. For example, let’s say that taxes are 30%. You have a $100 bond outstanding that you pay 10%, simple interest ($10/year). This costs you $7 ($10 interest, $3 tax benefit). So you have to adjust the net income for that tax shield as if you were unlevered. You must add back the tax shield (which is tax rate x the interest expense).

FCF = Net Income +/- change in working capital +/- depreciation/amortization/other non-cash items + tax shield on debt (and other Financing and Investment cash flows) – capex.