What is the difference between FCFF and FCFE, and when would you use each one?
I always confuse the two free cash flow measures. Both start from some form of income but the adjustments are different. How do FCFF and FCFE relate to each other, and which is better for valuation?
Free cash flow to the firm (FCFF) represents cash available to ALL capital providers -- both debt holders and equity holders. Free cash flow to equity (FCFE) represents cash available only to equity holders after satisfying debt obligations.
FCFF (Cash to Everyone)
FCFF = Net Income + Non-Cash Charges + Interest Expense x (1 - Tax Rate) - Fixed Capital Investment - Working Capital Investment
Or starting from EBIT:
FCFF = EBIT x (1 - Tax Rate) + Depreciation - CapEx - Change in Working Capital
FCFE (Cash to Equity Only)
FCFE = FCFF - Interest Expense x (1 - Tax Rate) + Net Borrowing
Or more directly:
FCFE = Net Income + Non-Cash Charges - CapEx - Change in Working Capital + Net Borrowing
Relationship:
FCFE = FCFF - Interest x (1 - t) + Net Borrowing - Debt Repayment
Example: Copperton Industries reports:
| Item | Amount |
|---|---|
| Net income | $800,000 |
| Depreciation | $200,000 |
| Interest expense | $150,000 |
| Tax rate | 25% |
| Capital expenditures | $350,000 |
| Increase in working capital | $75,000 |
| New debt issued | $100,000 |
| Debt repayments | $50,000 |
FCFF:
= $800,000 + $200,000 + $150,000 x (1 - 0.25) - $350,000 - $75,000
= $800,000 + $200,000 + $112,500 - $350,000 - $75,000
= $687,500
FCFE:
= $800,000 + $200,000 - $350,000 - $75,000 + ($100,000 - $50,000)
= $625,000
Verification: FCFE = FCFF - Interest x (1-t) + Net borrowing
= $687,500 - $112,500 + $50,000 = $625,000 (matches)
When to Use Each
- Use FCFF when the company's capital structure is changing significantly or when leverage is very high. Discount at WACC.
- Use FCFE when the capital structure is stable and you want to value equity directly. Discount at the cost of equity.
- FCFF is generally preferred for cross-company comparisons because it is capital-structure neutral.
Exam Tip: The CFA exam frequently asks you to compute one from the other. The bridge between them is after-tax interest expense and net borrowing. Memorize both formulas and practice the reconciliation.
Explore our CFA Level I course for more valuation cash flow examples.
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