FCFF vs FCFE: Which Cash Flow to Discount

A company generates cash. Some of that cash belongs, in principle, to everyone who financed the business — both lenders and shareholders. Some of it, after the lenders have already been paid their interest and principal, belongs only to shareholders. Discounted cash flow valuation forces a choice between these two: value the cash flow available to everyone (firm value), or the cash flow left over for shareholders alone (equity value). Pick the wrong discount rate for whichever cash flow you chose, and the valuation breaks even if every other input is correct.

Think of a rental property owned partly with a mortgage. The property's total rental income, before the mortgage payment, is the cash flow available to both the bank and the owner — that's the firm-level view. After the mortgage payment comes out, whatever's left is the cash flow available to the owner alone — that's the equity-level view. Valuing the owner's stake requires discounting the after-mortgage cash flow at the owner's required return, not the property's overall return, and valuing the whole property requires discounting the pre-mortgage cash flow at a rate that reflects both the bank's and the owner's required returns blended together.

Building each cash flow

$$\text{FCFF} = \text{EBIT} \times (1 - t) + D\&A - \text{CapEx} - \Delta \text{NWC}$$

In words: start from operating profit after a hypothetical unlevered tax (as if the company had no debt, since FCFF is meant to be capital-structure-neutral), add back depreciation and amortization (non-cash charges), and subtract the cash actually spent on capital expenditures and the increase in net working capital. This is the cash the business throws off, before any financing decisions.

$$\text{FCFE} = \text{FCFF} - \text{interest} \times (1-t) - \text{principal repaid} + \text{new debt issued}$$

In words: take that firm-level cash flow and subtract what actually goes to lenders (after-tax interest and any debt paydown), adding back any new borrowing — what remains is what shareholders could, in principle, receive in full.

Worked example

A company has EBIT of $200 million, a 25 percent tax rate, D&A of $40 million, capital expenditures of $60 million, and an increase in net working capital of $10 million. It pays $20 million of after-tax interest, makes $15 million of scheduled debt repayment, and issues no new debt this year.

$$\text{FCFF} = 200 \times (1 - 0.25) + 40 - 60 - 10 = 150 + 40 - 60 - 10 = 120 \text{ million dollars}$$ $$\text{FCFE} = 120 - 20 - 15 + 0 = 85 \text{ million dollars}$$

If WACC is 8 percent and the cost of equity is 11 percent (higher, because equity bears more risk than the blended capital structure), and both cash flows are assumed to grow at 3 percent in perpetuity:

$$\text{Enterprise value} = \frac{120}{0.08 - 0.03} = \frac{120}{0.05} = 2{,}400 \text{ million dollars}$$ $$\text{Equity value} = \frac{85}{0.11 - 0.03} = \frac{85}{0.08} = 1{,}062.5 \text{ million dollars}$$

Enterprise value minus net debt should reconcile to roughly the equity value from the FCFE approach (small gaps arise from growth-rate and discount-rate assumption differences between the two methods in practice) — the two paths are meant to arrive at a consistent answer for what shareholders own, just built from opposite directions.

What this means in practice

FCFF and WACC is the standard choice for companies with changing or hard-to-forecast capital structure (common in leveraged buyouts, high-growth companies raising and repaying debt irregularly), because it sidesteps modeling debt schedules explicitly and backs into equity value only at the end, by subtracting net debt. FCFE and cost of equity is more direct when a company's leverage is stable and predictable, particularly for financial institutions like banks, where "debt" (deposits) is part of core operations rather than discretionary financing, and FCFF's EBIT-based construction doesn't cleanly apply.

Key terms

• FCFF — free cash flow to the firm; cash available to all capital providers, discounted at WACC.
• FCFE — free cash flow to equity; cash available to shareholders after debt obligations, discounted at the cost of equity.
• WACC — weighted average cost of capital, the blended required return across debt and equity.
• Enterprise value — the value of the whole firm, before separating out debt and equity claims.
• Equity value — enterprise value minus net debt, or the direct output of discounting FCFE.