“Understand the Difference- FCFF and FCFE”

Hi Friends! Hope my last post might help you in gaining some insights about FCFF and FCFE.  Let’s begin today’s journey with a basic question i.e. what is difference between FCFF and FCFE in terms of cash flow?  FCFF is actually the cash available to bond holders and stock holders after all expense and investments have taken place whereas FCFE is the cash available to stock holders after all expense, investments and interest payments to debt-holders on an after tax basis.

Hence the basic difference lies because of consideration of interest payment in FCFE i.e. in FCFE you subtract the interest expense from the cash flow to do valuations. Hence, FCFF shows the obligations for both stockholders as well as bondholders whereas FCFE consider only the obligations for stockholders. Apart from the difference mentioned above and in my last post about FCFF and FCFE, there lies some more difference which is basically related to approach that we will use while doing valuation.( Will discuss in details in my later post)

Now, the question is how do we calculate the FCFF and FCFE? FCFF can be calculated by using the formulae as mentioned below:-

FCFF = EBIT (1- t) + Depreciation + Amortization – Change in Non- Cash Working Capital

– Capital Expenditure

Where,

EBIT = Earnings before income tax

t      = Corporate tax rates

Whereas FCFE can be calculated by using formula mentioned below,

FCFE = Net Income + Depreciation + Amortization – Change in Non- Cash Working Capital

*(1-D) – Capital Expenditure*(1-D)

Where,

D     = Debt ratio

Now, there lies two important points about these formulas, those are as follows:-

1)      In FCFF, we use EBIT (1-t) whereas in FCFE, we use Net Income; this is because while using EBIT (1-t) in FCFF we do not consider the effect of interest payment as mentioned above.

2)      IN FCFE, we use Change in Non- Cash Working Capital*(1-D) – Capital expenditure*(1-D) whereas in FCFF we use  Change in Non-Cash Working Capital – Capital Expenditure; this is because we just want to concentrate on cash flow due to equity only.

The calculation of FCFF or FCFE is the first step to do valuations. Now, the important question is what are the important factors that we must consider while calculating EV through FCFF and FCFE methods? The different factors that one must consider are as follows:-

 Factors FCFF FCFE Cash Flows Pre Debt Cash Flows (already mentioned above) post Debt Cash Flows (already mentioned above) Expected Growth Growth in Operating Income = Reinvestment rate * ROC Growth in Net Income  = Retention ratio * ROE Discount Rate WACC Cost of Equity Beta Bottom- up Bottom-up

These factors are of no use until you know about the assumptions you must take while calculating EV through FCFF and FCFE methods. Hence, the art of valuations lie in your understanding about these factors and its uses which I will explain later.

Hope this post helps you in understanding the difference between FCFF and FCFE from cash flows perspectives. Be ready to explore the world of assumptions in valuations in my next post.