Free cash flow is one of the critical metrics in valuation and project finance. However, calculating FCF accurately can be tricky, especially when dealing with restricted cash inflows. This blog delves into the nuances of FCF calculation, highlighting common mistakes and guiding you through the correct approach to account for restricted cash inflows.

Through a detailed case study, this blog aims to illustrate how the correct treatment of such inflows is crucial in computing a project's IRR.

## Case Study Overview

A company is entering into a project requiring total capital expenditure of INR 2,800 million, out of which INR 1,200 million will be funded through a zero coupon bond, maturing in year 5. The company wants to secure the funding upfront, and will therefore, raise the debt at the start of the project. The debt raise will have to kept in an escrow account and can be utilised only for construction purpose.

### Project Details:

Borrowing: INR 1,200 million for the construction of the project raised at the start.

Project Expenditure:

Year 1: INR 1,000 mn.

Year 2: INR 1,800 mn.

Operating Cash Flow Generation:

Year 3: INR 1,250 mn.

Year 4: INR 1,150 mn.

Year 5: INR 900 mn.

At the end of the fifth year, the company will have to repay INR 1,900 mn towards maturity value of the zero-coupon bond.

Compute the free cash flow to equity (FCFE) of the project

## Limitations of textbook formula

The standard text-book formula defines FCF to equity as follows:

`FCFE = Operating cash flow - Capex + Net borrowings`

So, if one were to go purely by textbook formula, an analyst may end up computing FCFE as follows:

Year 0: +1,200 mn (zero coupon debt)

Year 1: -1,000 mn (Capex)

Year 2: -1,800 mn (Capex)

Year 3: +1,250 mn

Year 4: +1,150 mn

Year 5: -1,000 mn (900 mn of operatin cash flow - 1,900 mn of repayment)

Since we have positive inflows in the initial and later years and negative cash flows in between, the above problem is likely to have multiple IRRs. And the standard IRR function (without the guess parameter) in MS Excel returns IRR as 21.0% for the above set of cash flows, which makes it look like an attractive project.

The problem here is that we are assuming that the initial debt is part of the free cash flow to equity. However, this cash flow is meant for capex and it cannot be distributed to the shareholders. And, therefore, it cannot be considered as part free cash flow.

## Correct treatment of restricted cash flows

Most textbook formulae for FCFE are silent about restricted cash flows. However, given the fact that a cash flow is restricted (i.e. has a limitation on its use) means that it is not free and it has to be adjusted while calculating the free cash flow.

In this particular case, this is the correct calculation of FCFE

In the above calculation, any transfer to an escrow account is reduced from the free cash flow as it is not available for distribution. In Year 1 and Year 2, as the amount in the escrow account is being utilized to fund the capex, we are showing it as an inflow to arrive at the net free cash flow.

Interestingly, this project does not have an IRR but the sum of the total cash flow of the project is negative, which clearly indicates that this is not a financially viable project.

## The key takeaways from the case study

Restricted cash flows should always be reduced from cash flow. By definition, free cash flow is available for distribution. There are many situations where cash flows are not available for distribution. These should not be considered as free cash flow.

Be careful about IRR calculations when we have cash outflows occurring in the middle of the project year. In the illustration that showed incorrect treatment of debt, MS Excel returns an IRR of 21%. However, given that the total cash flow of the project is negative, this number could be extremely misleading.