How do I compute FCFE when the company is actively changing its capital structure?

When a company is actively changing its capital structure — either leveraging up or deleveraging — the FCFE model becomes more complex because net borrowing is a significant non-zero term.

FCFE Formula:

> FCFE = FCFF - Int(1-T) + Net Borrowing

Or equivalently from NI:

> FCFE = NI + NCC - FCInv - WCInv + Net Borrowing

Example — Merriweather Industries (fictional):

Merriweather has $200M in debt and plans to repay $25M/year for 4 years, then maintain stable debt.

Notice how FCFE jumps sharply in Year 5 when deleveraging stops. The terminal value should reflect the stable capital structure, not the transitional one.

Best Practice for Changing Leverage:

1. Explicit Forecast Period: Model each year's net borrowing individually during the transition
2. Terminal Value: Use the target capital structure in the terminal year — net borrowing = 0 (or equal to reinvestment at the target ratio)
3. Discount Rate: If leverage is changing, the cost of equity changes too. Some analysts prefer FCFF/WACC for deleveraging scenarios because WACC is more stable
4. Consistency Check: Verify that projected debt levels are consistent with projected interest expense

Exam Tip: The CFA exam loves scenarios where FCFE and FCFF give different signal clarity. When capital structure is unstable, FCFF/WACC is often more reliable. If forced to use FCFE, model net borrowing carefully year by year.

Explore FCFE valuation in our CFA Level II practice questions.