the difference between free cash flow (FCF) and free cash flow to equity (FCFE) is not quite clear to me. The formula for calculating FCF is: CF from operating activities - CF from investing activities. Within the calculation, the interest payments to the lenders are already included in the income statement and thus in the net income for the year. The free cash flow is therefore available to the equity investors and can be used in the next period, for example, to pay out dividends, repay debts or for investments. Am I getting it right so far?
The FCFE (cash flow from operating activities - CF from investing activities + net borrowing) is, in my understanding, also defined as the cash flow available to equity holders. What exactly is the difference between FCFE and FCF? The mathematical difference is the net borrowing, which is added in order to calculate the FCFE. However, the FCF already shows how large the part of the CF is that would be available to the equity investors. If I have, for example, a net borrowing of -500,000 EUR, this would mean that I have reduced debts in this amount and have recorded an outflow of liquid funds. The EUR -500,000 should then appear in the CF from financing activities under “Repayment of debt”. Why would these -500,000 EUR be subtracted to calculate the FCFE? Other items from the CF for financing activities are not deducted. I cant tell why this is made in the first place. Is there any advantage using this approach when valuing the Equity and not the simple FCF?
You have to conceptually understand FCFF and FCFE before you understand the calculations.
FCFF, or free cash flow to firm, is the cash generated from the period available to capital providers. So a firm can use the FCFF to pay down debt (interest or principal).
FCFE, or free cash flow to equity, is the cash generated that’s avalable for distribution to common shareholders after… it has serviced debt. That’s why you consider cash from financing (which may reflect debt paydown of princiapl) in FCFE so that now it’s the money you have avilable to pay shareholders… after you paid down debt. Does that make sense?
No. When you say interest expense is included in net income, it means it has been deducted. This means the net income available only belongs to the equity holders because debt holders have been paid already when interest was deducted. When interest expense is added back to net income then the sum represents a combined amount for both creditors and stockholders.
“The mathematical difference is the net borrowing, which is added in order to calculate the FCFE”
Incomplete. The difference is not adding back interest and net borrowing or net repayment.
“However, the FCF already shows how large the part of the CF is that would be available to the equity investors.”
Wrong:
FCF = CF to both creditors and stockholders
FCFE = only to stockholders
“Why would these -500,000 EUR be subtracted to calculate the FCFE”
Because the the cash flow is not FREE for use or distribution to stockholders because th3 500k was used for investment (i.e. to grow the firm).
“Is there any advantage using this approach when valuing the Equity and not the simple FCF?”
FCF and FCFE are used in firm and equity valuation.
You can use either but the cost of capital will be different:
FCF = cost of debt and equity (you are valuing the total firm)
FCFE = cost of equity (you are valuing only the owners’ interest)