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.