Free cash flow to the firm (FCFF) and to equity (FCFE)

What is free cash flow, and how do FCFF and FCFE differ?

Free cash flow is cash left over after the business has paid its way and invested. FCFF is the version for everyone who funds the company, lenders and shareholders together. FCFE is the version for shareholders alone, after the lenders have been paid.

Free cash flowcash left after investing in the business

• Generic free cash flow Know the idea CFO − capital expenditures
• FCFF Memorize available to debt and equity holders
  • From CFO + Int(1 − t) − FCInv
  • From net income + NCC + Int(1 − t) − FCInv − WCInv
• FCFE Memorize available to shareholders only
  • From CFO − FCInv + net borrowing
  • From FCFF − Int(1 − t) + net borrowing

The generic measure is simply operating cash flow minus capital expenditures. Valuation needs sharper versions, and these two come back in the equity valuation topic. Free cash flow to the firm is what the business throws off once it has paid its running costs and taxes and funded the plant and working capital it needs, before anything goes to lenders or owners. Free cash flow to equity goes one step further: it also takes out what lenders receive (interest and principal, net of any new borrowing), leaving only what common shareholders could be paid.

$$\text{Free cash flow} = CFO - \text{capital expenditures}$$

How do you calculate FCFF from operating cash flow?

Start with reported CFO, add back the interest the company paid, net of the tax saving, and subtract net investment in fixed capital.

$$FCFF = CFO + Int(1 - t) - FCInv$$

Interest is a payment to a capital provider, so it belongs in the cash available to the firm. The add-back is after-tax interest , not the full amount, because interest is tax deductible: CFO already includes the tax saving, so the net cost that came out of CFO was Int × (1 − t).

The fixed capital investment is capital expenditures net of what the company received from selling long-term assets.

$$FCInv = \text{capital expenditures} - \text{proceeds from sale of long-term assets}$$

Questions come from either side: FCFF given and CFO, or the tax rate, or net capex missing. Use the solver to rearrange.

How do you calculate FCFF from net income?

Rebuild CFO from net income by adding non-cash charges and subtracting the investment in working capital, then apply the same add-back and capex deduction.

$$FCFF = NI + NCC + Int(1 - t) - FCInv - WCInv$$

Non-cash charges (NCC) are depreciation, amortization and similar items that reduced net income without costing cash. Remove any non-cash gains as well. Working capital investment (WCInv) is the cash tied up in receivables and inventory net of payables, the same quantity that appears as a working capital change in the indirect method.

How do you calculate FCFE?

Start with CFO, subtract net fixed capital investment and add net borrowing. Interest is not added back, because shareholders only get what is left after lenders are paid.

$$FCFE = CFO - FCInv + \text{Net borrowing}$$

Net borrowing is new debt raised minus debt repaid. When repayments exceed new borrowing it is negative, and FCFE falls. The link between the two measures follows from the formulas.

$$FCFE = FCFF - Int(1 - t) + \text{Net borrowing}$$

Exam tip When the question lists both new borrowing and repayments, net them first. Adding only the new debt is a built-in distractor.

What changes under IFRS?

Check where the company put interest and dividends before touching CFO. The formulas assume CFO is on the US GAAP basis: interest paid deducted, dividends paid not deducted, interest and dividends received included.

Where did the company put it?check the classification first

• Interest paid in financing (IFRS) Memorize CFO was never reduced by it
  • No after-tax interest add-back
• Dividends paid in operating (IFRS) Memorize CFO was reduced by them
  • Add them back to CFO
• Interest or dividends received in investing (IFRS) Memorize CFO leaves them out
  • Add them to CFO

Under US GAAP no adjustment is needed beyond the formula. Under IFRS the company chooses where to show these items, so the rule is to fix CFO only for what was classified differently.

Go deeper Why FCFF and FCFE are discounted at different rates

FCFF belongs to both lenders and shareholders, so it is discounted at the weighted average cost of capital (WACC), which blends the two. FCFE belongs to shareholders only, so it is discounted at the cost of equity. Using the wrong rate with a cash flow is a classic valuation error, which is why these two measures matter beyond this module.

Go deeper IFRS and FCFE: interest in financing

If an IFRS company shows interest paid in financing, its CFO has not been reduced by interest. FCFF then needs no add-back, but FCFE needs a deduction: shareholders are paid after the lenders, so take off the interest paid in full. Not after tax, because the tax saving from the interest deduction already sits inside CFO through lower taxes paid. So FCFE = CFO − interest paid − FCInv + net borrowing. (Strictly, the same logic means FCFF should also strip out that tax saving, Int × t. The exam’s rule for FCFF is simply “no add-back”, so answer that way.)

Go deeper Negative free cash flow in a growing company

A fast-growing company often has negative free cash flow because it invests heavily ahead of sales. That is not a warning by itself. What matters is whether the investment earns a return and how the gap is funded. The same negative number in a declining company that is not investing would be a real concern. Level II extends these measures with earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation, and amortization (EBITDA) routes, which are not needed here.