Free Cash Flow to the Firm vs. Free Cash Flow to Equity

Free cash flow models can be further categorized into two types. There are certain kinds of models which pertain to free cash flow that the firm as a whole will generate whereas there are others that pertain solely to the perspective of equity shareholders.

These models are quite different from each other. It is therefore essential to understand, when and under what circumstances is one model a better choice than the other. This article will explain the difference between these two types of free cash flow models:

Free Cash Flow To The Firm:

  • Interpretation:This is the amount of cash flow which is available to all the investors of the firm which would typically include bondholders as well as shareholders. The cash flow being considered here is operating cash flow and is generated by using the operating assets of the firm. If there are other assets like cash, marketable securities or any other kind of investments which are not used in day to day operations, their discounted present value needs to be added separately to the value of the firm as they are not considered in the free cash flow to the firm metric.

  • Discount Factor:Since the cash flow in FCFF pertains to the entire firm, it must be discounted at the weighted average cost of capital i.e. WACC. The idea is that the costs of debt and equity must be combined in the exact proportion in which they are being used. Also, tax benefits arising because of usage of debt are to be considered.

  • Formula:The formula for calculating the value of the firm using FCFF approach is as follows:

Value (Firm ) = Σ FCFF/ (1+(WACC))^n

Free Cash Flow To Equity:

  • Interpretation:Free cash flow to equity is the amount of cash flow that accrues to equity shareholders after all the operating, growth, expansion and even financing costs of the company have been met. Since this is the amount which is expected to be paid to equity shareholders, the value of equity shares can be directly calculated using these values.
  • Discount Factor: Since FCFE pertains only to equity shareholders, it needs to be discounted at a rate which reflects its level of risk. The risk of being an equity shareholder is higher than the risk of the entire firm if the firm is leveraged. Thus, the appropriate discount factor for these cash flows will be expected return on equity.
  • Formula:The value of a firm’s equity can be calculated in one of these two ways:
    1. By discounting all the future free cash flows to equity at return on equity.
    2. Value (Firm’s Equity) = ΣFCFE/ (1+(Return on Equity))^n
    3. By subtracting the discounted present value of debt from the discounted present value of the firm.

Value (Firm’s Equity) = Value (Firm) Value (Firm’s Debt)

Thus, it is possible to calculate the value of the firm’s equity by an indirect route even if we are not aware of what the free cash flows to that firm’s equity shareholders will be.

Important:

  • FCFF calculates the total value of the firm whereas FCFE calculates the value of the firm’s equity. In a levered firm, the value of a firm’s equity is a subset of the total value of the firm. Thus they are not two different methods to calculate the same output! The output derived from discounting FCFF is the firm’s value whereas that derived from discounting FCFE is the value of the firm’s equity.

  • FCFF must be discounted at the weighted average cost of capital i.e. WACC whereas FCFE must be discounted at the expected cost of equity. Discounting the wrong cash flow with the wrong discount factor will obviously lead to a wrong valuation!

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Equity Valuation