Corporate finance often feels like a web of acronyms — EBITDA, EBIT, EBIAT, FCF, WACC, IRR, hurdle rate — that all seem connected but not quite clear.
This guide stitches them together into two intuitive chains:
- How operating profits translate into cash flows (EBITDA → FCF)
- How investor required returns translate into project evaluation (rE → WACC → IRR)
🧩 Part 1: From EBITDA to Free Cash Flow (FCF)
The goal of this chain is to track how accounting profit turns into real cash that investors can receive.
The Income Statement Flow
| Step | Metric | Description |
|---|---|---|
| Revenue (Sales) | Money from operations | |
| – COGS, SG&A | Operating expenses | |
| = EBITDA | Earnings Before Interest, Taxes, Depreciation, and Amortization — operating profit before non-cash and financing effects | |
| – Depreciation & Amortization | Non-cash charges for asset usage | |
| = EBIT | Earnings Before Interest and Taxes — also called Operating Income | |
| – Taxes on EBIT | $ t_C \times EBIT $ | |
| = EBIAT (or NOPAT) | Earnings Before Interest After Taxes — after-tax profit from operations | |
| + Depreciation | Add back non-cash expense | |
| – Δ Working Capital | Subtract additional cash tied in operations | |
| – Capital Expenditures | Subtract investments in assets | |
| = Free Cash Flow (FCF) | Cash available to all capital providers |
Formula Summary
\[EBIAT = EBIT \times (1 - t_C)\] \[FCF = EBIAT + Dep - \Delta NWC - CapEx\]Example
| Item | Amount ($) |
|---|---|
| Sales | 10,000 |
| COGS + SG&A | 7,000 |
| Depreciation | 500 |
| EBIT | 2,500 |
| Taxes (30%) | 750 |
| EBIAT | 1,750 |
| + Depreciation | +500 |
| – CapEx | –800 |
| – ΔNWC | –200 |
| Free Cash Flow | 1,250 |
Interpretation:
EBITDA shows earnings capacity, EBIT shows operating profit, EBIAT shows after-tax operations, and FCF shows actual cash generation — the foundation for firm value in DCF models.
💰 Part 2: From Cost of Capital to IRR and Hurdle Rate
Once you have FCF, you need a discount rate to value it.
That’s where cost of capital concepts link together.
The Investor’s Perspective
| Term | Represents | Formula / Logic |
|---|---|---|
| Cost of Equity ($r_E$) | Return required by shareholders | $ r_E = r_f + \beta_E (r_M - r_f) $ |
| Cost of Debt ($r_D$) | Interest rate paid to lenders | after-tax: $ r_D(1 - t_C) $ |
| Weighted Average Cost of Capital (WACC) | Firm’s overall required return | \(WACC = \frac{E}{V}r_E + \frac{D}{V}r_D(1 - t_C)\) |
| Cost of Capital ($r_A$) | Unlevered return on assets | $ r_A = \frac{E}{V}r_E + \frac{D}{V}r_D $ |
| Internal Rate of Return (IRR) | Project’s expected rate of return | Solves $ NPV = 0 $ |
| Hurdle Rate | Manager’s minimum acceptable rate | Typically ≥ WACC |
Example
Assume:
- $r_f = 3\%$, $\beta_E = 1.2$, $(r_M - r_f) = 7\%$
- $r_D = 6\%$, $t_C = 30\%$
- $E/V = 70\%$, $D/V = 30\%$
If a project’s IRR = 12%,
then $ IRR > WACC $ → accept (NPV > 0).
Firms often add a cushion (the “hurdle rate”), e.g. target 14%, to account for risk or strategic conservatism.
🧩 Conceptual Chain
EBITDA → EBIT → EBIAT → FCF → Firm Value
↑ ↓
rE, rD → WACC → Hurdle Rate → IRR → Investment Decision
Decision rule:
\[IRR > WACC \implies NPV > 0 \implies \text{Value creation.}\]💬 Key Takeaways
- EBITDA → FCF traces how accounting profits become cash flows.
- rE / rD → WACC → IRR traces how investor expectations become decision rules.
- Together, they connect operations to value — the central idea of corporate finance.
“Finance is just converting earnings to cash flows and risk to discount rates — and making sure the second exceeds the first.”
Tags: #CorporateFinance #Valuation #WACC #EBITDA #DCF