Behavioral Life Cycle Theory
There have been many economic theories developed in order to understand how and why human beings save and spend their resources. Up until now, most of these theories have been developed based on the principles of theoretical finance. The first theory to be put up in this regard was developed by Modigliani in the year […]
The Failure of Long Term Capital Management (LTCM)
For centuries, men have held the ambition to be able to beat the market consistently. Year after year many traders try new strategies to be able to win consistently in the market. However, their strategies predictably fail creating the belief that the market is invincible and that the ability to beat the market consistently is […]
Types of Quotations in Forex Market
Forex quotations can be quite complex for the average person. It takes some training and knowledge to understand that these quotations can be provided in more than one way! Also, it takes a little getting used to before a person can quickly comprehend these quotes and take quick decisions based on the same. In this […]
How Variable Lease Works in Retail?
Leasing has traditionally been one of the biggest expenses related to the retail industry. This expense is incurred by almost every retail company across the world. However, over the years, retail companies have found it problematic to pay a fixed lease to landlords. This is because such lease agreements create operational leverage on their balance […]
How Does The Failure of Silicon Valley Bank Affect Stakeholders
The fall of the Silicon Valley Bank happened very suddenly. The bank had gone from a healthy functioning bank to near bankruptcy within 48 hours! As a result, the credibility of the entire American banking system has been brought into question. This is because commercial banks are not like regular organizations. In most cases, they […]
We studied the different methods to calculate the free cash flow to the firm (FCFF) in the previous articles. In this article, we will learn about how to derive free cash flow to equity (FCFE). Here too there are multiple methods involved.
However, since we already have a background in calculating cash flows, we need not go into that much detail here.
The calculation of free cash flow to equity is closely linked to the free cash flow to the firm calculation. There are slight differences which need to be highlighted in this article. To understand these differences we need to understand the concept of net borrowing.
Firms could be borrowing money and paying off debt at the same time. This could be because they are refinancing the debt at a cheaper interest rate.
Alternatively, a firm could simply be rolling over its debt to maintain a target debt amount.
Hence there are inflows and outflows that occur as a result of this simultaneously. The firm’s cash position will therefore experience simultaneous inflows and outflows.
We need to consider only the net effect of these flows. This can be calculated in the following manner.
This formula is of utmost important while calculating free cash flow to equity (FCFE) and will be used in each of the three cases possible.
Let’s have a look at the details:
We understood that the difference between free cash flow to the firm and the cash flow from operations was simply the investment in fixed assets. We do not consider investment in fixed assets to be a part of the cash flow from operations. However, we do consider it while calculating free cash flow to the firm. Hence we arrived at the formula:
FCFF = CFO – FC Investments
In case of free cash flow to equity (FCFE) we need to add one additional step. We need to account for borrowings as well. Now, we are only concerned with the cash that will be available for equity shareholders. Hence if we borrow more, more cash becomes available. If we pay off some debt, we are left with less cash. Notice we are talking about repayment of debt principal. The interest payments have already been accounted for.
Therefore, we need to consider the net effect of the borrowing as well to arrive at free cash flow to equity. The formula for the same is:
Once again, lets understand the free cash flow to equity (FCFE) formula in contrast to the free cash flow to firm (FCFF) formula. The formula for deriving free cash flow to firm (FCFF) from net income was:
FCFF = Net Income + Non cash Expenses + After Tax Interest – FC inv – WC Inv
Now, with regards to the after tax interest expenses, we do not need to add them back. As far as the cash flow to equity shareholders is concerned, interest expenses are included in the outflow and hence do not need to be added back.
Also, once again we need to add back the net borrowing figure since it affects that cash that is available to the equity shareholders. The modified formula therefore is
Lastly, we have the simplest case of calculating free cash flow to equity (FCFE) if we are given free cash flow to the firm (FCFF) as input. Remember that the difference between free cash flow to equity (FCFE) and free cash flow to firm (FCFF) is only the debt part. Hence, we need to make 2 adjustments.
Thus, to derive free cash flow to equity (FCFE) from free cash flow to firm (FCFF), the formula is:
It is therefore possible to calculate free cash flow to equity from various types of inputs.
Your email address will not be published. Required fields are marked *
Calculating Free Cash Flow to the Firm: Method #2: Cash Flow From Operations
February 12, 2025
