# Level 1 CFA® Exam:

FCFF & FCFE

We distinguish between two types of free cash flows: Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE).

Free cash flows show us what is the amount of cash available to the firm (both debtors and owners) in the case of FCFF __OR__ firm owners in the case of FCFE, after spending cash on all operating expenses, investment in fixed assets, and investment in working capital.

Of course, in the case of FCFE, we should also adjust free cash flow for cash paid and received from debtors.

### FCFE – Definition & Formulas

Free Cash Flow to Equity is a cash flow available to the company’s common shareholders:

FCFE = net income + non-cash charges – working capital expenditures – fixed capital expenditures + net borrowing

In this formula:

- working capital expenditures, in other words, investment in working capital, can be computed as the increase of working capital over the period, and
- net borrowing is the difference between issued debt and repaid debt. Of course, in a situation when a company repays more debt than issues a new one, we talk about net debt repayment.

Now let’s have a look at other formulas that are often used to compute FCFE.

\(FCFE = CFO - FCInv + B_{net}\)

- \(FCFE\) - the cash flow available to the company's common stockholders after necessary costs have been paid
- \(CFO\) - the cash flow from operating activities
- \(FCInv\) - capital expenditures
- \(B_{net}\) - net borrowing

\(FCFE = CFO - FCInv - DR_{net}\)

- \(FCFE\) - the cash flow available to the company's common stockholders after necessary costs are paid
- \(CFO\) - cash flow form operating activities
- \(FCInv\) - capital expenditures
- \(DR_{net}\) - net debt repayment

FCFE equals cash flow from operations less investment in fixed capital plus net borrowing (or minus net repayment).

These formulas are true if and only if cash flow from operations equals net income plus non-cash charges minus working capital expenditures. So, it is true for companies reporting under U.S. GAAP.

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First of all, we use FCFE in ratio analysis.

However, FCFE is also used to value companies. Discounted cash flow valuation methods apply different types of cash flows. One of the cash flows we can use is FCFE.

If we estimate future FCFEs and discount them using the cost of equity, we will get the value of the company’s equity. After dividing this value by the number of shares, we will get the intrinsic value of one share.

The table presents information about a company that is reporting under U.S.GAAP:

USD, millions | |
---|---|

CFO | 12.5 |

Interest paid | 1 |

Investment in fixed capital | 6.2 |

Net borrowing | 3.5 |

What is the value of the company’s FCFE?

(...)

Free Cash Flow to the Firm (FCFF) is a cash flow available to the company’s suppliers of debt and equity capital.

Have a look at the first formula:

\(FCFF=NI+NCC+Int\times(1-T) - FCInv - WCInv\)

- \(NI\) - net income
- \(NCC\) - non-cash charges
- \(Int\) - interest expense
- \(FCInv\) - capital expenditures
- \(WCInv\) - working capital expenditures
- \(T\) - tax rate

As you remember, the first formula for FCFE states that:

Free cash flow to equity equals net income plus non-cash charges minus working capital expenditures minus fixed capital expenditures plus net borrowing.

If to this formula for FCFE we add a cash flow available to debtors, that is interest expense multiplied by (1 less tax rate) less net borrowings, we’ll get the formula for FCFF.

There is also another formula for FCFF that you can use in your level 1 CFA exam - with cash flow from operations:

\(FCFF = CFO + Int\times (1 - T) - FCInv\)

- \(FCFF\) - free cash flow to the firm
- \(CFO\) - cash flow form operating activities
- \(Int\) - interest expense
- \(T\) - tax rate
- \(FCInv\) - capital expenditures

Of course, in this case, we should also remember about the necessary adjustment under IFRS, namely:

- we add interest received and dividend received to the formula if they were classified as investing activities,
- we subtract after-tax interest paid if it was classified as a financing activity, and
- we add dividends paid if they were classified as operating activities.

We can use FCFF for companies' valuation. If we estimate future FCFFs and discount them using the company’s WACC, we will get the value of the company.

So, in the case of FCFE, we discount future FCFEs using the cost of equity and get the value of equity, and in the case of FCFF, we discount future FCFFs using the weighted average cost of capital and get the enterprise value.

The table presents information about a company that is reporting under U.S.GAAP:

USD, millons | |
---|---|

CFO | 12.5 |

Interest paid | 1 |

Investment in fixed capital | 6.2 |

Tax rate | 20% |

Compute the value of the company’s FCFF and the value of the company assuming that the FCFF won’t change in the future and WACC amounts to 10%.

(...)

- Free cash flows show us what is the amount of cash available to the firm (both debtors and owners) in the case of FCFF OR firm owners in the case of FCFE, after spending cash on all operating expenses, investment in fixed assets, and investment in working capital.
- Free Cash Flow to Equity is a cash flow available to the company’s common shareholders.
- Free Cash Flow to the Firm (FCFF) is a cash flow available to the company’s suppliers of debt and equity capital.
- For valuation purposes, in the case of FCFE we discount future FCFEs using the cost of equity and get the value of equity, and in the case of FCFF we discount future FCFFs using the WACC and get the enterprise value.