Hi,
I have been confused about debt to asset ratio in calculation of free cash flow to equity.
Following is my understanding.
The Debt to Asset ratio of 40% means that 40% of capital investment will be raised through new debt and the rest 60% through current earnings. Hence we are deducting the 60% of Capital investment from Free cash flow to equity.
Also, we do not add the newly raised 40% as a part of net borrowing to FCFE because that would again have to be deducted as capital investment.
Please confirm if my understanding is correct.
So here 40% is funded by debt and the rest by “equity”. So the reason you deduct 60% of capez and working cap is because that is the portion funded by equity holders. Remember, fcfe is the cash available to investors after all expenses have been cleared off.
There would be times when the mgmt may provide a target cap structure going forward(eg - 40% debt). And thats when u take 1-0.4 to only get the portion of cap funded by equity. When no such info is available we add back net borrowings to offset the inclusion of debt in wc and capex. Recall the formula: NI+NCC-FCinv-Wc+Net borrowings So here, because you’ve included even the debt portion of capex n wc to be subtracted, we offset it by adding net borrowings as we want only equity funded portion.
Hope this helps.
ohk thanks saurabh. so, is my understanding correct then?
I don’t quite understand your final para but from what I perceive you add net borrowing to offset the inclusion of debt in your capex and wcap as we need only equity funded portion. So if that’s what your saying, your correct.