- CFA Exams
- 2024 Level II
- Topic 5. Equity Valuation
- Learning Module 24. Free Cash Flow Valuation
- Subject 1. FCFF and FCFE valuation approaches

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##### Subject 1. FCFF and FCFE valuation approaches PDF Download

**Free Cash Flow to the Firm (FCFF)**: Cash available to shareholders and bondholders after taxes, capital investment, and WC investment.

**Free Cash Flow to Equity (FCFE)**: Cash available to stockholders after payments to and inflows from bondholders. It is the cash flow from operations net of capital expenditures and debt payments (including both interest and repayment of principal).

Free cash flow models belong to the group of discounted cash flow valuation models. They are quite similar to another DCF model - the dividend discount model. The main difference is the definition of cash flows. It is also very important to use the correct rate for discounting free cash flows in the two models. The discounting rate is the average cost of capital supplied by the parties that have claims on the cash flow. Consequently, we use WACC for discounting FCFF and cost of equity for discounting FCFE.

__Present value of FCFF__

Firm value = FCFF discounted at the WACC.

_{t}/ (1 + WACC)

_{t})]

Σ: t = 1 to infinite.

Equity value = firm value - debt value.

_{d}

MV

_{d}: the market value of debt.

Dividing the total value of equity by the number of outstanding shares gives the value per share.

WACC can be either based on the current market weights of equity and debt or target weights. In case of market weights-based WACC, the formula is

_{d}/ [MV

_{d}+ MV

_{e}] x r

_{d}(1 - T) + MV

_{e}/ [MV

_{d}+ MV

_{e}] x r

_{e}

Where

- MV
_{d}is the market value of debt. - MV
_{e}is the market value of equity. - r
_{d}is the pre-tax cost of debt. - r
_{e}is the cost of equity. - T is the tax rate.

The cost of debt can be obtained directly from the market as the yield to maturity on the company's debt or comparable companies' debt. To calculate the cost of equity we can use methods such as CAPM, APT or cost of debt plus risk premium.

If FCFF is growing at a constant rate g, the value of the firm is:

_{1}/(WACC - g) = FCFF

_{0}(1 + g) / (WACC - g)

__Present value of FCFE__

Equity value = FCFE discounted at the required return on equity (r).

These cash flows belong to the stockholders only. Therefore, the present value of FCFE stream gives us the intrinsic value of a company:

_{t}/ (1 + r

_{e})

^{t}]

Σ: t = 1 to infinite.

Similarly, if FCFE is growing at a constant rate g, the value of the equity is:

_{1}/(r - g) = FCFE

_{0}(1 + g) / (r - g)

__Strengths and limitations of the FCFE model.__

Advantages:

- Wide applicability for different dividend and financing policies.
- In contrast to dividends, a record of free cash flows is observable for any company.
- Since FCF model is based on the capital exceeding operational needs, it is useful for valuation of control ownership that allows investors to redeploy this capital.

Disadvantages:

- If FCF < 0 due to capital demands.

__The implicit ownership perspective__

- FCF models are useful for control perspective. Acquirer can change the firm's dividend policy.
- Dividend discount models are useful for minority shareholder perspective with no control over dividend policy.

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**User Contributed Comments**
1

User |
Comment |
---|---|

americade |
Many growth early stage companies would get around the high capex fcf problem by simply adding the capex (or r&d) back in to contrive a fcf number. |

I am happy to say that I passed! Your study notes certainly helped prepare me for what was the most difficult exam I had ever taken.