Free Cash Flow: FCFF versus FCFE
Free cash flow is the cash a business throws off after it pays operating costs and taxes and funds the reinvestment needed to keep running. Valuation rests on cash, not accounting profit, so the build-up deliberately starts from an accounting figure (EBIT or Net Income) and converts it to cash. Two definitions matter. Free cash flow to the firm (FCFF), the project or firm measure, is the cash available to all capital providers, both debt and equity, before financing flows. Free cash flow to equity (FCFE) is what remains for shareholders after debt is serviced, so . The tax in FCFF uses unlevered operating profit, which is why it differs from the tax line inside Net Income.
Try it yourself
Discount free cash flow to the firm at the WACC, add a terminal value for the years beyond the explicit horizon, and you get enterprise value. Subtract net debt to reach equity value, then divide by shares for the per-share figure. Watch how much of the answer the terminal value alone carries.
In the TV-heavy case the narrow WACC − g_T gap pushes almost the whole value into the terminal value. That fragility is why analysts stress-test g_T.
Cash, not accounting profit:FCFF is cash to all capital providers after reinvestment (roughly EBIT(1 − tax) + D&A − capex − ΔNWC), not net income or EBIT. Earnings accrue revenue and expense before cash actually moves, so a profitable firm can still have weak FCFF.
Reflect: when the terminal value is 80%+ of EV, the valuation rests less on the five years you forecast carefully and more on one perpetual-growth guess. Does a longer explicit horizon genuinely reduce that reliance, or does it just move the same uncertainty further out?
Why it matters
Net Income is an accountant’s opinion. It is shaped by accrual rules and depressed by non-cash charges such as depreciation, and it sits after interest, so it already mixes in financing. Free cash flow strips that back to the money you could actually pull out of the business. Start from operating profit, tax it as if the firm had no debt, add back the non-cash charges, then subtract the real cash uses of capital spending and working-capital growth. FCFF answers what the whole enterprise generates. FCFE narrows that to the slice left for owners once lenders are paid. The two measures are not the same, and a valuation has to match the right cash flow to the right claim.
Formulas
Worked examples
A firm reports EBIT of US$400, a 25 percent tax rate, depreciation of US$60, capital expenditure of US$90, and a US$20 rise in operating net working capital. It also pays US$50 of interest. Find FCFF and FCFE, and show why the FCFF tax differs from the Net Income tax.
NOPAT is US$400 times 0.75, which is US$300. FCFF is 300 plus 60 minus 90 minus 20, which is US$250. For FCFE, the after-tax interest is US$50 times 0.75, which is US$37.50, so FCFE is 250 minus 37.50, which is US$212.50, assuming no principal movement. Note the tax gap. FCFF taxes the full EBIT of US$400 (tax of US$100) because it ignores financing. Net Income instead taxes EBIT minus the US$50 interest, that is US$350 (tax of US$87.50), since interest is deductible. The US$12.50 difference is the interest tax shield, which FCFF deliberately excludes and the WACC captures later.
Common mistakes
- ✗Free cash flow equals Net Income. Net Income is an accrual figure that sits after interest and includes non-cash charges. Free cash flow is a cash figure built before financing for FCFF, so the two routinely differ.
- ✗FCFF and FCFE are interchangeable. FCFF is cash to all investors and is discounted at the WACC. FCFE is cash to shareholders only and is discounted at the cost of equity. Mixing the cash flow with the wrong rate double counts or omits the effect of debt.
- ✗Depreciation is a cash outflow in the build-up. Depreciation is a non-cash accounting charge, so it is added back. The genuine cash use of investment is capital expenditure.
- ✗The tax inside FCFF is the same tax the firm actually pays. FCFF uses the unlevered tax on EBIT. The firm’s real tax bill is lower because interest is deductible, and that gap is the interest tax shield handled through the discount rate.
Revision bullets
- •Free cash flow is a cash measure, deliberately distinct from accounting Net Income
- •Accounting ladder: Revenue minus COGS minus OpEx is EBIT, plus D&A is EBITDA
- •FCFF is cash to all investors: EBIT(1 minus T) plus D&A minus CapEx minus change in ONWC
- •FCFE is cash to equity: FCFF minus after-tax interest and net debt repayment
- •FCFF taxes the full EBIT (unlevered), Net Income taxes EBIT after deducting interest
- •Discount FCFF at the WACC, discount FCFE at the cost of equity
Quick check
Why does the tax figure subtracted inside FCFF differ from the tax figure inside Net Income?
Free cash flow to equity (FCFE) is best described as
Connected topics
Sources
- Titman & Martin, Ch. 2Titman, S., & Martin, J. D. Valuation: The Art and Science of Corporate Investment Decisions. Pearson.Defines project (firm) free cash flow versus equity free cash flow and the EBIT-to-cash build-up.
- Damodaran (2005)Damodaran, A. "Dealing with Cash, Cross Holdings and Other Non-Operating Assets: Approaches and Implications." Working paper, 2005.Treats cash and marketable securities as financing, not operating, assets, which keeps them out of operating net working capital in the build-up.