How does the flow-to-equity method value just the equity portion, and when is it preferred over WACC or APV?
The CFA curriculum presents three valuation methods: WACC, APV, and FTE. I understand WACC discounts FCF at the blended rate and APV separates tax shields. But FTE discounts cash flows to equity holders at the cost of equity. When does this approach give different results, and when should I use it?
The flow-to-equity (FTE) method values equity directly by discounting the cash flows available to equity holders -- after debt service -- at the levered cost of equity. When applied correctly, it yields the same equity value as WACC or APV, but approaches the problem from the equity holder's perspective.\n\nFTE Formula:\n\nFCFE = FCF - Interest x (1 - t) - Net Debt Repayment + Net Debt Issuance\n\nEquity Value = sum of FCFE_t / (1 + r_e)^t\n\nKey Distinction:\n- WACC: discounts FCF (available to all capital providers) at WACC to get V, then subtracts D to get E\n- APV: values unlevered firm + tax shields to get V, then subtracts D to get E\n- FTE: discounts FCFE (available only to equity holders) at r_e to get E directly\n\nWorked Example:\n\nHargrove Consumer Products has:\n- FCF Year 1: $8.5M\n- Outstanding debt: $20M at 6.5% interest\n- Annual debt repayment: $2M/year\n- Tax rate: 28%\n- Levered cost of equity: 15.2%\n- Growth rate of FCFE after Year 5: 3%\n\nYear 1 FCFE:\n- Start with FCF: $8.5M\n- Subtract after-tax interest: $20M x 6.5% x (1 - 0.28) = $0.936M\n- Subtract principal repayment: $2.0M\n- FCFE Year 1 = $8.5M - $0.936M - $2.0M = $5.564M\n\nYear 2 FCFE (debt = $18M):\n- FCF: $9.1M (growing)\n- After-tax interest: $18M x 6.5% x 0.72 = $0.842M\n- Principal: $2.0M\n- FCFE Year 2 = $9.1M - $0.842M - $2.0M = $6.258M\n\nDiscounting at r_e = 15.2%:\n\n| Year | FCFE | PV Factor | PV |\n|---|---|---|---|\n| 1 | $5.564M | 0.8681 | $4.830M |\n| 2 | $6.258M | 0.7536 | $4.715M |\n| 3 | $6.988M | 0.6542 | $4.572M |\n| 4 | $7.610M | 0.5679 | $4.322M |\n| 5 | $8.134M | 0.4930 | $4.010M |\n| Terminal | $8.378M / (15.2% - 3%) | 0.4930 | $33.85M |\n| Total Equity Value | | | $56.30M |\n\nWhen to Use FTE:\n- Financial institutions where equity value is the primary focus\n- Situations where debt payments are contractually fixed and known\n- When you want to directly value what equity investors receive\n- Leveraged transactions with complex debt structures\n\nCommon Pitfalls:\n- Using r_e when you should use WACC (or vice versa)\n- Forgetting to adjust interest for the tax benefit\n- Mixing FCF (for WACC) with FCFE (for FTE)\n\nAll three methods yield identical equity values when assumptions are consistent.\n\nMaster valuation frameworks in our CFA Corporate Issuers course.
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