FCFE vs. FCFF: when should I use each, and how do I avoid double-counting debt effects?

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.