FCFE vs. FCFF: what's the difference and when should I use each for valuation?

Question

AcadiFi · Accepted Answer

The FCFE vs. FCFF distinction is one of the most important conceptual frameworks in CFA Level II equity valuation. Getting this wrong means using the wrong discount rate, which invalidates your entire valuation.

**The Fundamental Difference:**

- **FCFF** = Cash available to ALL capital providers (debt + equity). Discount at **WACC**.
- **FCFE** = Cash available to EQUITY holders only (after debt payments). Discount at **cost of equity (r)**.

**Formulas:**

$$FCFF = NI + NCC + Int(1-t) - FCInv - WCInv$$

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

Or equivalently:
$$FCFE = FCFF - Int(1-t) + Net Borrowing$$

Where:
- NCC = Non-cash charges (depreciation, amortization)
- FCInv = Fixed capital investment (capex)
- WCInv = Working capital investment
- Int(1-t) = After-tax interest expense

**Worked Example: Kensington Industrial Group**

| Item | Amount |
|---|---|
| Net Income | $82M |
| Depreciation | $24M |
| Interest Expense | $18M |
| Tax Rate | 25% |
| Capex | $35M |
| WC Increase | $8M |
| New Debt Issued | $12M |
| Debt Repaid | $7M |

**FCFF:**
= $82M + $24M + $18M(1-0.25) - $35M - $8M
= $82M + $24M + $13.5M - $35M - $8M
= **$76.5M**

**FCFE:**
= $82M + $24M - $35M - $8M + ($12M - $7M)
= $82M + $24M - $35M - $8M + $5M
= **$68.0M**

Note: FCFE = FCFF - Int(1-t) + Net Borrowing = $76.5M - $13.5M + $5M = $68.0M (checks out)

```mermaid
flowchart TD
    CF["Cash from Operations"] --> FCFF["FCFF = $76.5M
Available to ALL investors"]
    FCFF --> DC["Debt Claims
Interest - Tax Shield
$13.5M"]
    FCFF --> NB["Net Borrowing
+$5.0M"]
    DC --> FCFE["FCFE = $68.0M
Available to EQUITY only"]
    NB --> FCFE
    FCFF -.-> W["Discount at WACC
→ Firm Value"]
    FCFE -.-> E["Discount at Cost of Equity
→ Equity Value"]
    style FCFF fill:#c9a84c,color:#0a0a0f,stroke:#c9a84c
    style FCFE fill:#c9a84c,color:#0a0a0f,stroke:#c9a84c
    style W fill:#1a1a2e,color:#fff,stroke:#c9a84c
    style E fill:#1a1a2e,color:#fff,stroke:#c9a84c
```

**When to Use Each:**

| Situation | Use FCFF | Use FCFE |
|---|---|---|
| Changing capital structure | Preferred | Avoid (FCFE changes with leverage) |
| Levered company, stable debt | Either works | Simpler |
| Negative FCFE (high debt service) | Works fine | Problematic (negative value) |
| Valuing the whole firm | Required | Cannot directly |
| Valuing equity directly | Subtract debt from firm value | Direct approach |

**Getting Equity Value from FCFF:**
Firm Value = FCFF / (WACC - g)
Equity Value = Firm Value - Market Value of Debt
Value per Share = Equity Value / Shares Outstanding

**Exam Tip:** If a company has significant leverage changes planned, use FCFF because WACC is more stable than the cost of equity when leverage shifts. If the question provides net borrowing data and asks for equity value directly, use FCFE.

Practice FCF valuation models in our CFA Level II question bank on AcadiFi.

FCFE vs. FCFF: what's the difference and when should I use each for valuation?

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Practice Questions

Item	Amount
Net Income	$82M
Depreciation	$24M
Interest Expense	$18M
Tax Rate	25%
Capex	$35M
WC Increase	$8M
New Debt Issued	$12M
Debt Repaid	$7M

Situation	Use FCFF	Use FCFE
Changing capital structure	Preferred	Avoid (FCFE changes with leverage)
Levered company, stable debt	Either works	Simpler
Negative FCFE (high debt service)	Works fine	Problematic (negative value)
Valuing the whole firm	Required	Cannot directly
Valuing equity directly	Subtract debt from firm value	Direct approach