FCFE vs. FCFF: when should I use each, and how do I avoid double-counting debt effects?
I keep mixing up free cash flow to equity (FCFE) and free cash flow to the firm (FCFF) on practice exams. Sometimes the vignette gives net income and sometimes EBITDA, and I'm not sure which formula to start with. Also, I've heard that a common mistake is double-counting the tax shield when going from FCFF to firm value. Can someone clarify the decision framework and walk through a clean example?
This is one of the highest-yield topics for CFA Level II — the FCFE/FCFF distinction shows up almost every exam. Here's a clear framework.
Decision Rule
| Situation | Use | Discount Rate |
|---|---|---|
| Stable capital structure | FCFE | Cost of equity (r_e) |
| Changing leverage / highly leveraged | FCFF | WACC |
| Financial institution | Neither — use dividend or RI models | — |
Use FCFF when leverage is expected to change significantly, because FCFF is independent of the capital structure. Use FCFE when leverage is stable and you want to value equity directly.
The Formulas
Starting from net income (most common for FCFE):
FCFE = Net Income + Depreciation - Capital Expenditures - Change in Working Capital + Net Borrowing
Starting from EBIT (most common for FCFF):
FCFF = EBIT(1 - Tax Rate) + Depreciation - Capital Expenditures - Change in Working Capital
Worked Example: Meridian Logistics
Year 1 forecast data ($ millions):
- Revenue: $820
- EBIT: $123
- Interest expense: $18
- Tax rate: 25%
- Depreciation: $34
- Capital expenditures: $52
- Increase in working capital: $11
- Net new debt issued: $15
- Shares outstanding: 40 million
- Cost of equity: 12.5%
- WACC: 9.8%
- Long-term growth rate: 3.5%
FCFF approach:
FCFF = $123 x (1 - 0.25) + $34 - $52 - $11
FCFF = $92.25 + $34 - $52 - $11 = $63.25M
Firm value (Gordon growth) = $63.25 / (0.098 - 0.035) = $63.25 / 0.063 = $1,003.97M
Equity value = Firm value - Market value of debt
Assume market value of debt = $180M
Equity value = $1,003.97 - $180 = $823.97M
Per share = $823.97 / 40 = $20.60
FCFE approach:
Net income = ($123 - $18) x (1 - 0.25) = $105 x 0.75 = $78.75M
FCFE = $78.75 + $34 - $52 - $11 + $15 = $64.75M
Equity value = $64.75 / (0.125 - 0.035) = $64.75 / 0.09 = $719.44M
Per share = $719.44 / 40 = $17.99
Why the Values Differ
The two approaches give different answers here because the assumed stable growth rate and discount rates embed different capital structure assumptions. In theory, with consistent assumptions, both methods converge. In practice, small inconsistencies in how the WACC, cost of equity, and growth rate interact cause differences.
The Double-Counting Trap
The classic mistake: using FCFF (which already excludes interest) but then subtracting interest again when computing firm value. Remember — FCFF is pre-financing cash flows. The cost of debt is captured in the WACC denominator, not subtracted from the numerator.
For structured FCFE vs. FCFF practice problems with step-by-step solutions, check out AcadiFi's CFA Level II Equity Valuation module.
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