Free Cash Flow to Firm vs. Free Cash Flow to Equity Growth Rates

pacmandefense's picture
Rank: Baboon | 104

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:

jdm05520 - Private Equity Associate:
  1. 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.
  2. 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.

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Comments (31)

Mar 19, 2012

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Mar 19, 2012

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Mar 19, 2012
  1. Yes.
  2. No. A requirement to use the WACC is that the D/A ratio remains constant,
  3. A methodology is as good as it is consistent with others.
    • 1
Mar 19, 2012

hmm, thanks for your reply, Kraken. :D

I've always understood theoretically why FCFF and FCFE calculation of equity value are identical. (in principle)
But when i do actual valuation models using both techniques, they give slightly different results for equity value.
And, algebraically, I can't seem to prove that the equity value calculated are similar.

Any idea?
Thanks!

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Mar 19, 2012

YC, Any clue yet why they are difference?

Mar 19, 2012

bump

Apr 10, 2008
  1. 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.
  2. 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.

I assume you are asking the question as it relates to back of the envelop valuation techniques such as Dividend Discount Models, H-Model etc. FYI, IB and PE tend to use FCFF in valuation.

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Apr 10, 2008
jdm05520:

1. 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.

  1. 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.

I assume you are asking the question as it relates to back of the envelop valuation techniques such as Dividend Discount Models, H-Model etc. FYI, IB and PE tend to use FCFF in valuation.

thanks. i understand now. if we use FCFE as a forecast start point, we will have a huge range of valuations.

Mar 19, 2012

How can you just give an equity value of 250 then give me cash flows that prove equity isn't 250 given its discount rate of .12?

Mar 19, 2012

That is it. Thanks.
I was going in circles here.

  • Anonymous Monkey
  •  Jul 5, 2016

Old thread, but FWIW, a few flaws in the methods above.
Either WACC, or total debt(250) can be constant, not both. If you assume debt constant at 250, WACC will change each year due to changes in D/A.

For FCFE, tax shield from debt should be discounted at pre tax cost of debt and cf to equity at unlevered cost of equity (appropriate risk).

Fcfe and fcff are fundamently different approaches, yielding slightly different numbers(except for the general case where D/A is constant.
P.S. I'm an illiterate in finance, take all this with a grain of salt.

Mar 19, 2012

calculator I have the same gap in understanding as you did. Can you please provide a slightly more detailed explanation?

Mar 19, 2012

Is the problem that you are using the book value of equity rather than the market value of equity in the WACC?

Mar 19, 2012

Okay that's right, although this is much trickier to get working when growth is assumed. What I am having difficult modeling is that capital structure approaches 100% equity funding in perpetuity. Even when I bring the model out 100 periods it doesn't reconcile perfectly in the early periods. Damodaran seems to approach it differently (here http://www.stern.nyu.edu/~adamodar/pc/fcffvsfcfe.xls) so I will see if his method is practical.

It just frustrates me that my equity value will not reconcile perfectly between the two methods!

Apr 10, 2008

im looking for a quick answer. im CFA-ing right now and the test will ask that it is but not why. im just curious why (for my own personal learning).

Mar 19, 2012

No. The (1-D) terms don't make any sense.

In a year where debt is not taken out / repaid, FCFE is basically Cash From Ops - Capex. If you want to start with net income and get to free cash flow to equity, it should be something like:

Net Income
+D&A
- Increase in Working Capital
+/- Other Reconciling Items [i.e. adding back non-cash expenses, subtracting non-cash gains]
- Capital Expenditures
+/- Debt Raised / Repaid

Mar 19, 2012

@mk1275 In case of dividend recapitalization, would it be correct to add that cash to FCFE through your the formula you mentioned, especially "+/- Debt Raised/Repaid"?

Mar 19, 2012
nitau_gg:

Is this formula correct?
FCFE = Net Income + Depreciation + Amortization - Change in Non- Cash Working Capital *(1-D) - Capital Expenditure*(1-D)
Where,
D = Debt ratio
Source: https://finwinz.wordpress.com/2011/02/24/understan...

You ask some of the dumbest/weirdest questions on this site. Are you really employed at a bank?

    • 1
Mar 19, 2012

Yep, you'd use cost of equity.

Mar 19, 2012

Yes. Ke.

Mar 19, 2012

Cool thanks guys

Jul 5, 2016

dude, Google around or ask your fucking professor

Jul 5, 2016
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Jul 5, 2016
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