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FCFF vs FCFE

The FCFF and FCFE which are acronyms for (Free Cash Flow for the Firm) and (Free Cash Flow to Equity), are the two types of free cash flow measures. It is vital to understand FCFF vs. FCFE because the numerator and discount rate of multiples largely depend on the methods of cash flow used.

Free cash flow, otherwise known as (FCF), is the cash that a company or organization generates after they have accounted for cash outflows to support their operations and maintain their capital assets. FCF is different from net income because, with FCF, there is an exclusion of non-cash expenses and inclusion of the costs made on equipment and assets. 

Free Cash Flow also helps potential shareholders and lenders to examine the capacity of the company to pay its dividends or interests. In the following paragraphs, we’ll take a better look at the two types of free cash flow– FCFF vs. FCFE.

What Is FCFF?

The free cash flow for the firm, which is also known as Unlevered Free Cash Flow, is the amount of cash that is available to be distributed to shareholders after deducting working capital, capital expenditure, taxes, and depreciation expenses.

FCFF is the amount left after a company has made payments for its short-term and long-term obligations. 

Why Is FCFF Important?

FCFF measures the profitability of a company after all expenses and reinvestments have been made. To a large extent, one can say that FCFF is the most important financial indicator of a company’s stock price.

A proper understanding of the FCFF of a company will allow investors to test if a stock is reasonably valued. Financial analysts also make use of FCFF as a benchmark to compare and analyze the financial health of the firm.

What Does a Negative or Positive FCFF Mean?

The FCFF of a business can either be positive or negative. When you calculate the FCFF and the value is positive, it means that the firm has extra cash available after deducting its expenses. A negative value in FCFF, on the other hand, means that the firm has not generated enough revenue to cover its cost and investment activities.

If a business is left with a negative value FCFF, an investor can push to know why the revenue is lesser than investment costs. Sometimes it may be due to a particular business decision or an indicator of financial problems.

How To Calculate FCFF

You can calculate FCFF in different ways. Here are a few of them: 

Common Equation

The common equation for calculating FCFF is as follows:

FCFF = NI + NC + (I x (1 – TR)) – LI – IWC

The variables in the formula are explained thus;

NI = Net Income

NC = Non-cash charges

I = Interest

TR = Tax Rate

LI = Long-term investments

IWC = Investments in Working Capital.

Cash Flow Operations Equation

You can also calculate use the Cash Flow Operation Equation as follows: 

FCFF = CFO + (IE x (1 – TR)) – CAPEX

Where:

CFO = Cash flow from operations

IE = Interest expense

TR = Tax Rate

CAPEX = Capital expenditure.

EBIT Equation

Using the EBIT Equation, you can calculate FCFF thus: 

FCFF = (EBIT x (1 – TR)) – D – LI – IWC

Where:

EBIT = Earnings before interest and taxes

TR = Tax Rate

D = Depreciation

LI = Long term investment 

IWC = Investments in Working Capital

EBITDA Equation 

Alternative formula, using EBITDA Equation

FCFF = (EBITDA x (1 – TR)) + (D x TR) – LI – IWC

Where:

EBITDA = Earnings before interest, taxes, depreciation, and amortization.

Example of FCFF

Let’s consider the following example:

A firm has the following financial data;

$
Cash flow from operations2,000
Interest Expense200
Tax Rate40%
Acquisition of New Machine350

Using the Cash Flow Operation formula, we can calculate the FCFF as:

FCFF = 2,000 + (200 X (1 – 0.4) – 350

200 X 0.6 = 120

2,000 + 120 – 350

= $1,770

Assumptions of FCFF

While making projections with the FCFF, the firm’s value is hinged on assumptions and not an assurance that the projected FCFF will turn out as expected. As a result, you should incorporate the cost of capital so that the projected FCFF will have a significant relationship to the present value. 

What Is FCFE?

The Free Cash Flow to Equity, otherwise known as Levered Free Cash Flow, is a measure of equity capital usage. FCFE measures how much money the company can distribute to its equity shareholders as dividends or stock buybacks.

This amount available to be distributed to equity shareholders is calculated after deducting all the necessary expenses.

Why Is FCFE Important?

FCFE is essential because it measures how much money the company can distribute to its equity shareholders through dividends and stock buybacks. This method is reliable when you want to determine how a company finances stock repurchases and dividend payments.

Before potential investors decide to purchase or invest in a company’s shares, they examine the FCFE metric. This is so because even when a company’s cash flow is high, a considerable percentage might be geared towards settling current debts, leaving only a tiny portion distributed among shareholders.

Unlike other cash flow models, the FCFE is more definite in effectively measuring the financial value of a company.

A Negative FCFE

A negative FCFE implies that the firm will have to raise new equity in the near future. Some reasons that may lead to a negative FCFE are;

  • When a company uses its cash flow to settle debts
  • Any change in working capital, which also brings about cash outflow

It is important to note that a negative FCFE doesn’t mean that the company suffers from loss.

How To Calculate FCFE

You can calculate FCFE using any of the formulas below.

Net Income Formula

When using Net Income, FCFE is calculated thus;

FCFE = NI + D + ∆WC + CE + NB

Where;

NI = Net Income  

D = Depreciation & Amortization 

∆WC = Changes in Working Capital 

CE = Capital Expenditure 

NB = Net Borrowings

EBIT Equation

When using EBIT;

FCFE = (EBIT – (I + T)) + D + NB + CE + ∆WC

Where;

EBIT = Earnings before interest and tax

I = Interest paid 

T = Taxes paid 

D = Depreciation & amortization 

NB = Net Borrowings 

CE = Capital Expenditure 

∆WC = Changes in Working Capital

FCFF Equation

FCFE = FCFF + Net Borrowings – [interest x (1 – tax)]

Example of FCFE

The following information was obtained from a company’s Income Statement and Balance Sheet for 2018 and 2019.

Particulars2019 (million dollars)2018(million dollars)
Currents Assets250200
Fixed Assets350300
Depreciation & Amortization2520
Short term debt5040
Long term debt4030
Account payable4040

The company’s net income is $300,000,000

Therefore, net income = 300,000,000

Depreciation & Amortization = 25,000,000

Changes in working capital = Difference in Current Assets – Difference in Current liabilities (Accounts Payable), which is 50,000,000 – 0 = 50,000,000

Capital expenditure = 350,000,000 – 300,000,000 = 50,000,000

Net borrowings = Difference in long term debt + Difference in short term debt, which is 10,000,000 + 10,000,000 = 20,000,000

Using the formula on Net Income: 

FCFE = 300,000,000 + 25,000,000 – 50,000,000 – 50,000,000 + 20,000,000 = $245,000,000.

Assumptions of FCFE

In projecting and estimating the growth of a firm under the FCFE model, investors make the following assumptions: 

  • The firm is stable: capital expenditure is not greater than depreciation by a large percentage. Also, the beta of the firm’s stock should be below one or close to one 
  • The company’s leverage is stable
  • The company’s FCFE is significantly different from its dividend 

Key Differences Between FCFF and FCFE

The key differences between FCFF and FCFE are as follows:

  • FCFF doesn’t account for the impact of interest payments and net increases on a company’s value, but FCFE accounts for them.
  • FCFF is the remaining amount for all the firm’s investors, which includes bondholders and stockholders, but FCFE is the amount that is left for common equity holders of the firm.
  • In Discounted Cash Flow variation, FCFF calculates the enterprise value or total intrinsic value of the firm. However, FCFE determines the equity value or the firm’s intrinsic value available to common equity shareholders.

Bottom Line

The FCFF and FCFE are both based on inputs and assumptions. When valuing a company, it is imperative to examine the company and what stage the company is operating at. After determining the company’s position, you can then select the suitable method to use. 

Managers of highly leveraged companies prefer to use the FCFF because it provides a more appealing view of the sustenance of the firm. Analysts, however, would instead use the FCFE because it gives a more detailed picture of the sustenance of the firm. If the FCFE is negative, it will be preferable to use the FCFF for valuation.

Both methods are reliable in the hands of someone who truly understands them. However, we recommend that you consult with a reputable financial advisor to ensure that you make the right choice given your circumstances.