I’m having trouble understanding this topic. I’ve searched AF for previous links on this topic but nothing really helped.
Can someone explain what exactly FCFF/E is all about. Why is it important and what does it tell you?
In Scheweser these are the formulas:
FCFF = NI + NCC + [Int * (1 - t)] + FCInv - WCInv
where:
NI = net income
NCC = noncash charges (depreciation and amortization)
Int = interest expenses
FCInv = fixed capital investments (net capital expenditures)
WCInv = working capital investment
what weird though is that in one of the Schweser practice exams answer it has the following:
FCFF = CFO + Int(1- t) - capital expenditures (is this just another way of expressing using indirect method conversion, apologies, I’m really shaky on FRA stuff)
and
FCFE = CFO - FCInv + net borrowing
where:
net borrowing = debt issued - debt repaid
I’m trying to memorise this stuff out of understanding rather than just formula memorisation. If someone can clarify these formulas, that would be greatly appreciated.
Also, interested in understanding where and why the 2 formulas are different (i.e. what is one telling vs. the other).
Thanks
Free cash flow is a widely used measure used by many analysts (Moody’s, S&P for example). It measures how much cash the firm produced for its stakeholders.
FCFF measures the cash produced for the debt and equity holders of the firm. It starts with CFO. Interest payment for the year are added back as typically they are available to the firms stakeholders. Net capital expenditures are taken away as cash spent on them is not available to the firms stakeholders.
FCFE measures the cash which remains for stockholders. It also starts with CFO, but doesn’t add in the interest payments as they are paid only to debtholders, and are thus not available to stockholders. If the firm has to use cash to pay back debtholders it is money the stockholders don’t have. Equally if the firm issues new debt, then the stockholders have in theory more cash.
I just remember the two formulas which start from CFO and don’t bother with the other formulas. If you understand what CFO consists of you should be able to calculate it if it is not given.
Hope this helps.
Hello Clever CFA,
FCFF is a cash flow available for both stakeholders i.e. debt holders and equity shareholders.
FCFF=((EBIT*(1-T)+Depreciation- Capex(±) Change in Working capital)…only these 4 terms need to be considered
FCFE is a cash flow which is available only to equity shareholders.
FCFE=((EBIT-I)*(1-T)+ Depreciation- Capex(±) Change in Working capital+ Debt drawdown- Debt Repayment)
Now, compare both formulaes and understand the differences and logic behind the differences.
FCFF doesn’t consider the interest deduction, debt repayments and debt drawdown.
Interest and debt repayments are cash outflows which need to be deducted while calculating the FCFE. Debt drawdown is being added back because in Capex deduction we have considered total capex (i.e.Debt+Equity), hence to consider only equity amount, debt drawdown is being added, ie.( -Capex+Debt drawdown)=(-Equity).
In case of FCFE formula, first term (EBIT-I)*(1-T) is nothing but PAT.
I hope this will help you.
Thanks and Regards,
Kailas Kale