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.
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equity value calculated using FCFF and FCFE (Originally Posted: 11/05/2011)
Hi guys,
I've a few questions.
1) Equity value calculated using or FCFF and FCFE are they always the same?
Under normal circumstances where D/E stays unchanged and WACC remains constant for the forecast period, I'm quite certain that Equity Value calculated from FCFF and FCFE are identical.
2) But when we forecast capital structure to change during forecasting period, will the equity value calculated from FCFF and FCFE still remain the same? Why so?
3) Are there any other factors that may cause the equity value to differ from each other?
Thanks!
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!
YC, Any clue yet why they are difference?
bump
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.
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.
equity value with FCFF and FCFE (Originally Posted: 05/26/2014)
Why an equity value that is calculated using FCFF differs from the equity value calculated using FCFE.
I know that this question has already appeared in forums here and it is usually answered as" they are equal". However I would like to ask this question again along with an example when the equality fails.
I am using standard formulas from CFA readings (or any other theory book).
Assumptions: Investment (Capital) = 500 Debt = 250 (50% from capital), perpetuity bond, coupon 9%, market interest rate 9% meaning that market value of debt is 250.
Interest = 250*0.09 = 22.5 Equity = 250 (50%), cost of equity = 12% Tax = 35% No capex investment beyond the initial No Changes in Working capital No depreciation Assume no change in probability of default
WACC = 0.50.650.09 + 0.50.12 = 8.925% FCFF = 50 to perpetuity FCFE = FCFF – Interest(1-T) = 50 – 22.5 * 0.65 = 35.375 Firm Value (using FCFF) = FCFF/WACC = 50/0.08925 = 560.224 Equity Value (using FCFF)= FCFF – D = 560.224 – 250 = 310.224
Equity Value (using FCFE) = FCFE/(cost of equity) = 35.375/0.12 = 294.792
Equity Value (using FCFF) is NOT equal Equity Value (using FCFE).
What do I miss?
Actually I have NEVER seen these two equal. Every example I have seen produces two different values. So, why is that so embedded in so many people to say that these are equal?
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?
That is it. Thanks. I was going in circles here.
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.
calculator I have the same gap in understanding as you did. Can you please provide a slightly more detailed explanation?
Is the problem that you are using the book value of equity rather than the market value of equity in the WACC?
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!
FCFE Formula (Originally Posted: 07/26/2015)
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/understand-the-difference-fcff…
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).
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
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"?
You ask some of the dumbest/weirdest questions on this site. Are you really employed at a bank?
FCFE-> equity value (Originally Posted: 01/09/2010)
When you're using levered FCF for a leveraged firm to calculate the equity value, you're using the Ke as your discount rate not the WACC right? Because you've taken out the interest expense? If not, can someone explain why you would still use the WACC?
Yep, you'd use cost of equity.
Cool thanks guys
FCFF FCFE different intrinsic equity? (Originally Posted: 04/05/2009)
Why do FCFF and FCFE give a different estimation of the intrinsic value of equity?
does it have to do with different assumptions of growth or the estimations of net debt?
thanks
dude, Google around or ask your fucking professor
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