LOS 23.bEquity Valuation · Free Cash Flow Models
FCFF vs FCFE: choosing and reconciling
Difficulty
Candidate-reported: Hard
Exam frequency
High — a recurring item-set anchor at Level II
Free cash flow to the firm (FCFF) and to equity (FCFE) answer different questions about the same business. Picking the wrong one — or discounting it at the wrong rate — is the classic Level II vignette trap.
Key points
- FCFF = NI + NCC + Int(1 − tax) − FCInv − WCInv; discount at the WACC to value the whole firm.
- FCFE = FCFF − Int(1 − tax) + Net borrowing; discount at the required return on equity to value equity directly.
- Use FCFE when capital structure is stable; prefer FCFF when leverage is changing, because WACC is steadier than the cost of equity.
Common pitfalls
- Discounting FCFF at the cost of equity (or FCFE at the WACC) — match the cash flow to its claimant.
- Forgetting the after-tax interest add-back when bridging FCFF to FCFE.
Source: CFA Program Curriculum, Level II — Equity Valuation, Free Cash Flow Valuation.