FCFF takes into account all value of the firm including what would be paid out as interest expense. FCFE is the value after debt financing; however, there is the added benefit of having claim to any debt issuance. FCFF models are better when the capital structure has a lot of debt and when FCFE is negative. FCFF is discounted by WACC. FCFE uses the required equity return. If we introduce preferred shares into the capital structure, WACC must factor the cost of capital. Pref shares should be treated like debt with dividend payments treated like interest expense (however, it is non-tax deductible). Value to equity holders can be found by taking firm value and subtracting market value of debt. Cash, marketable securities, land held for sales… these are all valuable assets of the firm that would not be included in the FCFF valuation and may need to be added to the final calculated value to get the true value of the firm. FCFF = NI + NCC + Dep + Int(1-t) - capex - wc FCFF = EBIT(1-t) + NCC + Dep - capex - wc FCFF = EBITDA(1-t) + NCC + Dep(t) -capex - wc Since EBITDA is pre depreciation expense, need to add back dep(t) FCFF = OCF + Int(1-t) - capex OCF already includes the NCC and DEP add backs FCFE = FCFF - Int (1-t) + net borrowing Must deduct the interest expense at this point, but benefit from net borrowings (which include pre share issuance) Common NCC - Depreciation and amortization (so basic) - Restructuring (ONLY is they will not be cash charges in the future. eg severence expense will become a cash expense but accelerated depreciation will not). - Bond discount amort - Deferred taxes (ONLY if we consider the balance to be growing forever and deferred taxes are really better viewed as equity). Other considerations - CAPEX should be net of cash proceeds from asset sales (not value over book… Cash!) - If not given a capex figure, calculate the change in GROSS pp&e - Changes in WC include cash outflow for increases in assets and cash inflow for increases in liabilities. Forecasting - If forecasting FCFE, need to assume that we want to keep the capital structure as is… this includes added the (1-Debt ratio) adjustment to our capex and working capital assumptions. - FCFE Forecast = NI + NCC - [(1-DR)x(capex - depreciation + changes in WC)] - Note that we take 1-DR, not just DR Other Notes - Generally, use WACC based on target capital structure - Growth rates for forecasting FCFF unlikely to equal those for FCFE - Forecast growth rates should be built off of a representative year in the business cycle, not a peak or trough - Financin decisions like dividend have no effect on FCFF. Debt issuance will only have a minor long term effect of FCFE as benefit of net borrowing offset by increased interest expense.
“FCFF models are better when the capital structure has a lot of debt” I don’t think that the actual capital structure matters; I believe it’s the volatility in the capital structure that determines whether using FCFE (which is preferred) is appropriate. "Cash, marketable securities, land held for sales… these are all valuable assets of the firm that would not be included in the FCFF valuation and may need to be added to the final calculated value to get the true value of the firm. " Huh? FCF valuation is valuing a company based on its future discounted cash flows; assets have no place in this valuation at all, except when you’re talking about CAPEX spending that is required to keep the business up and running. "FCFF = EBIT(1-t) + NCC + Dep - capex - wc " “NCC” and “Dep” are the same thing (non-cash charges).
“except when you’re talking about CAPEX spending that is required to keep the business up and running.” I didn’t get my point across very clearly there - assets have NO PLACE in FCF valuation, and the only place they’re considered is when forecasting what CASH outflow you’d need on a yearly basis in order to maintain your asset base.
Have to disagree with you. In the real world, and also in the text, it is noted that non cash generating assets are very important in valuing a firm. It is a shortfall of FCFF models that may need to be addressed, typically with natural resource companies. Break-out of Dep and NCC is just a convention. Dep is such a distinct item compared to other non-cash charged. If you have a huge debt load, you likely have a huge interest expense which results in negative FCFE – hence, FCFF is better.
"Have to disagree with you. In the real world, and also in the text, it is noted that non cash generating assets are very important in valuing a firm. It is a shortfall of FCFF models that may need to be addressed, typically with natural resource companies. " Um, pretty sure we’re saying the same thing here - a FCF model values a company based on cash flows, which may or may not be the best way to value certain companies. “Break-out of Dep and NCC is just a convention. Dep is such a distinct item compared to other non-cash charged.” I know that, and I assume that you know that, but for the rest of the phorum who (most likely) doesn’t look at financial statements as much as I do (and perhaps you do as well), I thought I’d simply point that out. You’re making that formula more complicated than it needs to be for what they need to know. “f you have a huge debt load, you likely have a huge interest expense which results in negative FCFE – hence, FCFF is better.” You’re assuming that the company’s profitability doesn’t outweigh the “huge” debt expense, which I would vigorously disagree with in most cases, as would the curriculum, I believe. For what we need to know, it’s the volatility of the cap structure, not the actual capital structure, that determines what FCF we choose to use.