The Daily Technical #19: If the Fed wants to lower rates, what can it do?

Good morning. Welcome to the 19th edition of The Daily Technical. You’re here for one reason so let’s dive in.

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OVERVIEW OF YESTERDAY’S QUESTION
What is the difference between unlevered FCF (FCFF) and levered FCF (FCFE)?

Start by understanding the core distinction: FCFF is for the firm overall, while FCFE narrows down to equity stakeholders. Here's a breakdown:

FCFF (Unlevered FCF) doesn’t consider interest payments or debt. It gives a picture of cash generated by core operations.

FCFE (Levered FCF) accounts for debt payments, providing cash flow available to just equity holders.

To calculate FCFF begin with EBIT (Earnings Before Interest and Taxes). It's key because it’s unaffected by debt interest, making it unlevered. Use EBIT, tax rate to get NOPAT, then adjust by adding depreciation/amortization, tweaking for net working capital changes, and subtracting capital expenditures.

FCFF = EBIT × (1 – Tax Rate) + D&A – Changes in NWC – Capex

To calculate FCFE start with Net Income since it already factors in interest expenses. Then add back non-cash items, adjust for changes in working capital, subtract capex, and add cash inflows/(outflows) from new borrowings, net of debt paydowns.

FCFE = Cash from Operations – Capex –Debt Principal Payment

Common Mistakes

1. Using EBIT for FCFE or Net Income for FCFF. Remember, EBIT is used to derive FCFF and Net Income is your go-to for FCFE because it reflects interest impacts.

2. Ignoring Tax Impacts: For FCFF, make sure to apply the correct tax rate to EBIT to get NOPAT. Skipping or miscalculating this step can misrepresent true cash flows.

3. Forgetting that FCFE must account for debt flows. If you overlook factoring in debt principal payments or assume they're handled the same as in FCFF, you’ll misrepresent equity cash flows.

Key Takeaways / TLDR

• FCFF reflects a firm’s cash irrespective of debt, while FCFE shows what's left after meeting debt obligations.

• Start with EBIT for FCFF (unlevered), and Net Income for FCFE (levered).

• FCFE must adjust for debt-related cash flows, unlike FCFF.

TODAY’S QUESTION
If the Fed wants to lower rates, what can it do?

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