FREE CASH FLOWS

FCFF and FCFE

Free Cash Flow to the Firm (FCFF)
and
Free Cash Flow to the Equity (FCFE)
 What is Free Cash Flow to the
Firm?
• Free Cash Flow to the Firm (FCFF) is the cash flow
available to the company’s suppliers of capital after
all operating expenses (including taxes) have been
paid and necessary investments in working capital
and fixed capital have been made.

• FCFF is the cash flow from operations minus capital

expenditure.
 What is Free Cash Flow to the
Equity (FCFE)?
• Cash flow available to the company’s holders of
common equity after all operating expenses,
interest and principal payments have been paid and
necessary investments in working and fixed capital
have been made.

• FCFE is the cash flow from the operations minus

capital expenditures minus payments to (and plus
receipts from) debtholders.
 Present Value of FCFF
•  The FCFF valuation approach estimates the value of the
firm as the present value of future FCFF discounted at the
WACC.

• Because FCFF is the cash flow available to all suppliers of

capital, using WACC to discount FCFF gives the total value
of all the firm’s capital.
• The value of equity is the value of the firm minus the
market value of its debt:
• Equity Value = Firm Value – Market Value of Debt
 Present Value of FCFE
•  The value of equity can also be found by
discounting FCFE at the required rate of return on
equity, r.

• FCFE is the cash flow remaining for equity holders

after all other claims have been satisfied.
• Discounting FCFE by ‘r’ (the required rate of return
on equity) gives the value of the firm’s equity.
 Computing FCFF from Net
Income
• FCFF is the cash flow available to the company’s
suppliers of capital after all operating expenses
(including taxes) have been paid and operating
investments have been made.

• The company’s suppliers of capital include

bondholders and common shareholders and
occasionally , holders of preferred stock.
 Computing FCFF from Net
Income
FCFF =
NET INCOME AVAILABLE TO COMMON SHAREHODERS (NI)

PLUS: NET NON-CASH CHARGES

PLUS : INTEREST EXPENSE X (1-TAX RATE)

LESS: INVESTMENT IN FIXED CAPITAL

LESS: INVESTMENT IN WORKING CAPITAL

 Computing FCFF from the Statement of
Cash Flows
• Analysts frequently use cash flow from operations,
taken from the statement of cash flows, as a starting
point to compute FCFF because CFO incorporates
adjustments for non-cash expenses as well as for net
investments in working capital.

FCFF =
CASH FLOW FROM OPERATIONS
PLUS: INTEREST EXPENSE X (1-TAX RATE)
LESS: INVESTMENT IN FIXED CAPITAL
FCFF with different starting points
A Non cash charge
NI EBIT (1-T) EBITDA (1-T) that affects taxes
must be accounted
for

+NCC +NCC +DEP * T

-WC INV -WC INV -WC INV

CFO

+INT (1-T) +INT (1-T)

-FC INV -FC INV -FC INV -FC INV

Exercise

SALES 1000
OPERATING EXPENSES 200
DEPRECIATION 200
INTEREST 300
TAX 40%
WC INVESTMENT 10
FC INVESTMENT 20
 Computing FCFE from FCFF
• FCFE is the cash flow available to equity holders only.
• To find FCFE, therefore, we must reduce FCFE by the after
tax value of interest paid to debtholders and add net
borrowings
FCFE =
Free Cash Flow to the Firm
LESS: Interest Expense X (1-Tax rate)
PLUS: Net borrowings (equal to new debt borrowing minus
debt repayment)
Or
FCFF – Interest Expense X (1-Tax rate) + Net borrowings
 Computing FCFE from FCFF
Free Cash Flow to Equity (FCFE) =
NET INCOME
PLUS: NCC
LESS: INVESTMENT IN FIXED CAPITAL
LESS: INVESTMENT IN WORKING CAPITAL
PLUS: Net borrowings (equal to new debt borrowing
minus debt repayment)

NET BORROWINGS = NEW DEBT ISSUED – DEBT PAID

 Case Let
• Assume you have forecasted the following for a
company:
• Number of shares outstanding 500,000 ; Beta 1.30;
Constant growth after year 4 is 5%;Expected Market
Return 10% and Risk Free Rate 4%
YEAR 1 YEAR 2 YEAR 3 YEAR 4
Net Income 800,000 850,000 900,000 940,000
Depreciation 200,000 250,000 225,000 275,000
Fixed 300,000 100,000 400,000 300,000
Investment
Invest in WC -50,000 100,000 -75,000 25,000
New Debt 150,000 75,000 180,000 150,000
Debt Paid 100,000 100,000 150,000 125,000
Case let cond.. Finding FCFE
FCFE 1 FCFE 2 FCFE 3 FCFE 4
Net Income 800,000 850,000 900,000 940,000
+ Depreciation 200,000 250,000 225,000 275,000
- Fixed Cost 300,000 100,000 400,000 300,000
- Invest in WC -50,000 100,000 -75,000 25,000
+ New Debt 150,000 75,000 180,000 150,000
- Debt Paid 100,000 100,000 150,000 125,000
FCFE 800,000 875,000 830,000 915,000
Case let Contd.. Finding Required
Return
Required Return:

R = Rf+ BETA * (RM-RF)

4% +1.30 * (10%-4%)
= 11.80%
Case let Contd.. Value of all FCFE in constant
growth stage
• 

= =

= = 14,128,676
 Case let contd.. – Value of Firm
Equity
• 

CF 1= 800,000; CF 2= 875,000;CF 3=830,000 and

CF4=915,000+14,128,676 = 15,043,676, K= 11.8%
NPV = 11,638,683

P0 = 11,638,683 / 500,000 = 23.28

Value per share = 23.28
Case let
Case Let - 1
Indicate the effect on this period’s FCFF and FCFE of a change
in each of the items listed here. Assume a $100 increase in
each case and a 40 percent tax rate.
• A. Net income.
• B. Cash operating expenses.
• C. Depreciation.
• D. EBIT.
• E. Accounts receivable.
• F. Accounts payable.
• G. Property, plant, and equipment.
• H. Notes payable.
• I. Cash dividends paid.
 Case let - 2
Proust Company has FCFF of $1.7 billion and FCFE of $1.3
billion. Proust’s WACC is 11 percent, and its required rate
of return for equity is 13 percent. FCFF is expected to
grow forever at 7 percent, and FCFE is expected to grow
forever at 7.5 percent. Proust has debt outstanding of
$15 billion.

• A. What is the total value of Proust’s equity using the

FCFF valuation approach?
• B. What is the total value of Proust’s equity using the
FCFE valuation approach?
Case let 3
• PHB Company currently sells for $32.50 per share.
In an attempt to determine whether PHB is fairly
priced, an analyst has assembled the following
information:
• The before-tax required rates of return on PHB
debt, preferred stock, and common stock are,
respectively, 7.0 percent, 6.8 percent, and 11.0
percent.
• The company’s target capital structure is 30 percent
debt, 15 percent preferred stock, and 55 percent
common stock.
Contd..
• The market value of the company’s debt is $145 million,
and its preferred stock is valued at $65 million.
• PHB’s FCFF for the year just ended is $28 million. FCFF
is expected to grow at a constant rate of 4 percent for
the foreseeable future.
• The tax rate is 35 percent.
• PHB has 8 million outstanding common shares.

What is PHB’s estimated value per share? Is PHB’s stock

underpriced?
 Case let 4
Watson Dunn is planning to value BCC Corporation, a provider of a variety of industrial metals
and minerals. Dunn uses a single-stage FCFF approach. The financial information Dunn has
assembled for his valuation is as follows:
• The company has 1,852 million shares outstanding.
• The market value of its debt is $3.192 billion.
• The FCFF is currently $1.1559 billion.
• The equity beta is 0.90; the equity risk premium is 5.5 percent; the risk-free rate is 5.5
percent.
• The before-tax cost of debt is 7.0 percent.
• The tax rate is 40 percent.
• To calculate WACC, he will assume the company is financed 25 percent with debt.
• The FCFF growth rate is 4 percent.
Using Dunn’s information, calculate the following:
A. WACC.
B. Value of the firm.
C. Total market value of equity.
D. Value per share.