FCFE Vs DCFF

Module 8
 FCFF VS FCFE

What is Free Cash Flow?

• Free Cash Flow is the amount of cash flow a firm generates (net of taxes) after
taking into account non-cash expenses, changes in operating assets and liabilities,
and capital expenditures.

• Free Cash Flow is a more accurate metric than EBITDA, EBIT, and Net Income as they
leave out large capital expenditures and change in cash due to changes in operating
assets and liabilities. Also, metrics such as EBIT and Net Income include non-cash
expenses, further misrepresenting the true cash flow of a business.

• Due to the reasons mentioned above, Free Cash Flow is often used in a DCF analysis
and therefore, a clearer understanding of the concept is important for finance
interviews, especially for Investment Banking and Corporate Finance roles.
 FCFF VS FCFE

Types of Free Cash Flow

There are two types of Free Cash Flows:

• Free Cash Flow to Firm (FCFF) (also referred to as Unlevered Free Cash Flow) and
• Free Cash Flow to Equity (FCFE), commonly referred to as Levered Free Cash Flow.

It is important to understand the difference between FCFF vs FCFE as the discount rate
and numerator of valuation multiples depend on the type of cash flow used.

Difference between FCFF VS FCFE

The key difference between Unlevered Free Cash Flow and Levered Free Cash Flow is
that Unlevered Free Cash Flow excludes the impact of interest expense and net debt
issuance (repayments) whereas Levered Free Cash Flow includes the impact of interest
expense and net debt issuance (repayments).
FCFF VS FCFE
FCFF VS FCFE
 FCFF VS FCFE

How to Calculate Unlevered Free Cash Flow

• EBIT * (1-Tax Rate) + Non-Cash Expenses – Changes in Operating Assets & Liabilities –
CapEx
• Cash Flow from Operations + Tax Adjusted Interest Expense – CapEx
• Net Income + Tax Adjusted Interest Expense + Non-Cash Expenses – Changes in
Operating Assets & Liabilities – CapEx

How to Calculate Levered Free Cash Flow

Net Income + Non-Cash Charges – Changes in Operating Assets & Liabilities – CapEx +
Net Debt Issued (Repaid)
Cash Flow from Operations – CapEx + Net Debt Issued (Repaid)
 FCFF VS FCFE
Valuation Multiples: FCFF VS FCFE

• While calculating valuation multiples, we often use either Enterprise Value or Equity
Value in the numerator with some cash flow metric in the denominator.

• If the denominator includes interest expense, Equity Value is used, and if it does not
include interest expense, Enterprise Value is used.

• Therefore, Equity Value is used with Levered Free Cash Flow and Enterprise Value is
used with Unlevered Free Cash Flow.

• Enterprise Value is used with Unlevered Free Cash Flows because this type of cash flow
belongs to both debt and equity investors.

• However, Equity Value is used with Levered Free Cash Flow as Levered Free Cash Flow
includes the impact of interest expense and mandatory debt repayments, and
therefore belongs to only equity investors.

• Similarly, if EBIT is in the denominator, Enterprise Value would be used in the

numerator and if Net Income is in the denominator, Equity Value would be used in the
numerator.
 FCFF VS FCFE

Discount Rate: FCFF vs FCFE

• If Unlevered Free Cash Flows are being used, the firm’s Weighted Average Cost of
Capital (WACC) is used as the discount rate because one must take into account the
entire capital structure of the company. Calculating Enterprise Value means including
the share of all investors.

• If Levered Free Cash Flows are used, the firm’s Cost of Equity should be used as the
discount rate because it involves only the amount left for equity investors. It ensures
calculating Equity Value instead of Enterprise Value.
 FCFF VS FCFE

Estimation of different inputs of FCFF Valuation

How do we estimate the different inputs that go into FCFF valuation?

• FCFF = EBIT(1-t) – (capital expenditures – depreciation) – (change in noncash working

capital)
• The growth rate in EBIT = Reinvestment rate * Return on capital (ROC)

Where:
• Reinvestment rate =
{(capital expenditures – depreciation) +(change in noncash working capital)} ÷ {EBIT(1-t)}
• ROC = {EBIT(1-t)} ÷ {BV of debt + BV of equity}
• The discount rate is the WACC = We*Ke + Wd*Kd(*1-t)
• The terminal value = {EBITn+1(1-t)(1-Reinvestment rate)} ÷ (WACCn – stable gowth rate}