In the study text, the following statement is given about why Cash and Short Term Debt is excluded from the computation of “Working Capital Investment” for the purposes of computation of FCFF (free cash flow to the firm):
Cash is excluded because it is the change in cash that we are trying to explain. Notes payable and current portion of LTD is excluded because they carry explicit interest costs and are therefore financing rather than operating items.
I unfortunately did not understand head or tail of this.
Why do we not count cash and short term debt in the computation of WCInv (working capital investment) when we calculate FCFF?
Cash on balance sheet at end of period = Cash on balance sheet at beginning of period + CFO + CFI + CFF
If we were to include cash in CFO, then it would become a circular calculation.
We do in fact consider changes in notes payable and current portion of long-term debt - we just consider them in CFF, not CFO. So changes in notes payable and current portion of long-term debt would impact FCFE but not FCFF, since FCFF is a “pre-levered” measure.
in a simple way, because the FCFF is the amount that the firm has to cover all the money suppliers(debt and equity), and if you take into account the short term debt in the computation of WC, you’ll be double counting