Temporary Housing Services Incorporated (THSI) is considering a project that involves setting up a temporary housing facility in an area recently damaged by a hurricane. THSI will lease space in this facility to various agencies and groups providing relief services to the area. THSI estimates that this project will initially cost $6 million to set up and will generate $22 million in revenues during its first and only year in operation (paid in one year). Operating expenses are expected to total $11 million during this year and depreciation expense will be another $2 million. THSI will require no working capital for this investment. THSI's marginal tax rate is 35%. Ignoring the original investment of $6 million, what is THSI's free cash flow for the first and only year of operation?

$7.85 million.

Explanation:

Free cash flow is the amount that is available for distribution to creditors and shareholders. It the amount that is left after paying for expenses, taxes, and making investments in required capital including working capital and operating capital. In corporate finance, free cash flow has significant importance. While evaluating corporation, these cash flows are discounted at the cost of capital to determine the value (worth) of a business. The equation that is used to calculate Free Cash Flow in this case is:

[(Revenue - operating expenses - depreciation) * (1 - Tax rate)] + depreciation

In simple words, it is the operating profit + depreciation. We add back depreciation to operating profit because it is a non-cash expense, similarly amortization if any should also be added back. It has been observed here that the capital investment is ignored here, it is because the question asks us to do it. If it is not mentioned in the question, then as I said FCF is the amount left after paying for all the expenses, taxes, and operating capital investments.

Simply put values in the above given formula:

⇒ FCF = [(22 - 11 -2) * (1 - .35)] + 2 = $7.85 million.