1. FCFF is preferable (to FCFE) for a company with a history of leverage changes, as its growth rate will be more stable than FCFE growth rate.
2. FCFF is better for a firm with high leverage.
can someon explain why?
What is Free Cash Flow?
Free cash flow is a measure of how much money is available to investors through the operations of the business after accounting for expenses of the business such as operational expenses and capital expenditures.
To answer the OP's original questions - user @jdm05520 shared:
- When a firm has a significant amount of past leverage changes the FCFE growth rate is skewed due to the inclusion of Principal and Interest payments in the FCFE calculation. FCFF does not account for principal and interest payments, rather it is calculated to arrive at the cash available to the firm's debt and equity holders.
- A firm with high leverage has a significant amount of P&I payments in the FCFE calculation historically making it difficult to assess the growth rate going forward.
Definition of Unlevered Free Cash Flow?
Typically, when someone is referring to free cash flow, they are referring to unlevered free cash flow (also known as Free Cash Flow to the Firm) which is the cash flow available to all investors, both debt and equity. When performing a discounted cash flow with unlevered free cash flow - you will calculate the enterprise value.
Free cash flow is calculated as EBIT (or operating income) * (1 - tax rate) + Depreciation + Amortization - change in net working capital - capital expenditures.
Definition of Levered Free Cash Flow?
While unlevered free cash flow looks at the funds that are available to all investors, levered free cash flow looks for the cash flow that is available to just equity investors. Levered Free Cash Flow is also known as Free Cash Flow to Equity. It is also thought of as cash flow after a firm has met its financial obligations. When performing a discounted cash flow with levered free cash flow - you will calculate the equity value.
Levered free cash flow is calculated as Net Income (which already captures interest expense) + Depreciation + Amortization - change in net working capital - capital expenditures - mandatory debt payments.
Even if a company is profitable from a net income perspective and positive from an unlevered free cash flow perspective, the company could still have negative levered free cash flow. This could mean that this is a dangerous equity investment since equity holders get paid last in the event of bankruptcy.
How to discount levered and unlevered free cash flow?
When performing a discounted cash flow analysis on unlevered free cash flow, you are examining the cash flow available to the entire capital structure - debt holders, equity holders, and preferred equity investors - and therefore you need to use the weighted average cost of capital which looks at the costs of capital across the capital structure.
When performing a discounted cash flow analysis on levered free cash flow, you are examining the cash flow available to equity investors and should just be using the cost of equity - or the capital asset pricing model (CAPM) to discount cash flows.
Preparing for investment banking interviews?
The WSO investment banking interview course is designed by countless professionals with real world experience, tailored to people aspiring to break into the industry. This guide will help you learn how to answer these questions and many, many more.
Investment Banking Interview Course
- 7,548 questions across 469 investment banks. Crowdsourced from over 500,000 members.
- Technical, behavioral, networking, case videos, templates. All included.
- Most comprehensive IB interview course in the world.