Why is net borrowing added to FCFF to get FCFE ? It seems odd that any new debt borrowing is added back to FCFF to get to FCFE bc if FCFE is what’s left for equity holders, then how can we include the new debt as part of free cash flow to equity holders? I’ve seen where some companies take out debt to issue dividends, and I think that’s what this implies but I’m not sure I get why it’s included in FCFE if it’s still debt, which will ultimately be paid back to bondholders. Any tips??
FCFE = Free Cash Flow available to all providers of Equity. This includes both Stock Holders and well as Bond Holders (Since they also contribute to the equity).
Not sure I follow. How do bondholders contribute to equity?
If I own a company (i.e., equity owner), and I borrow money from the bank (i.e., debt holders), I receive cash coming into the company (i.e., additional debt is a cash inflow). This has nothing to do with profit, just the movement of cash from one place to the other.
You have to add net borrowing to FCFF to arrive at FCFE because effectively the board of directors could issue new debt and pay out the proceeds as dividends, if they were so inclined. So technically the borrowed money is available to equity holders as free cash subject to the discretion of the board
Thanks Disko, that’s the only example I could think of as well. That makes sense, at least temporarily. I get that they receive the cash and can therefore immediately distribute it, but ultimately that must be repaid as a loan to bondholders, which wouldn’t be included in FCFE. 5x EBITDA, I see your point also, but it’s not just a cash inflow, a related liability is booked simultaneously. And if you take the net asset value (assets-liabilities), then you’re back to zero bc the cash and debt cancel out. Still seems odd that new debt can be included as fCFE. Is the ability to distribute the only answer, any other insight?
bondholders contribute to equity as 1. the assets go up.
they get a higher priority on the cash flows in the event of the company going belly up.
you see the entire term of net borrowings (new debt - repayment of old debt) being added to the FCFE term while calculating.
essentially - entire debt is added to the term. so when it is - any payment made on the debt should also be added. of course that payment is after removing the taxes - since that goes to the government.
This is definitional, as well.
FCFE is the cash available for equity investors and this can be generated through issuing debt. FCFF is the cash available to the firm prior to paying the providers of capital whereas after paying to the debt holders the interest payments the left over is for equity investors and the net borrowings (additional) have no other use as FCFF is after meeting all the cash requirements (operational) and once interest amount is paid yet the firm has additional borrowings (net) then they must be for equity investors.
A couple somewhat related questions, if 'all don’t mind.
1.) I know this is just math, but it seems odd still. Why does the actual capital structure not necessarily equal the target capital structure used in the WACC ? It seems like it should reflect the capital structure assumed in the discount rate.
2.) The DR (debt ratio) assumption in calculating FCFE is meant to simply the assumptions related to net borrowing by applying a target debt financing ratio, correct ?? Is this essentially saying that instead of trying to predict future repayments and issuances, this ratio just streamlines the annual hit to cash flow related to debt financing ??
In the case where debt issuances exceed debt payback, would the DR ratio be 1 or greater than 1 ? By applying (1-DR), this basically leaves you with only cash flows based on equity. Ok i get that, but if issuances exceed payback, then you’d actually be adding value/increasing the FCFE in which case you would apply a 1 or greater DR ratio, no??
Also, what does it mean when they say interest will grow by, say, 10%. If the annual interest/coupon is fixed, how is the annual interest amount growing ?? And how do you convert/know the per share debt value if all the problem says is that debt has a face value of $32 million…the answer is 32, but how do you know that that is the per share debt value? Thanks!
Wow this seems like a lot of bs in just one post. Did you really mean this, cpk?
The simple answer is that if I borrow a bunch of money, I could immediately give it to my shareholders as a dividend if I wanted to; thus, that cash is available to equity and is included in FCFE.
Stupid, perhaps, but possible.
Out of curiosity, what possessed you to look back at a thread that’s over six months old?
Google. Seriously. I had the exact same question as the op poping up one evening and I used google. And sure enough the forum shows up as first reference…
I’ve heard of Google.
You are misleading serious students with your embarrassing advise. I guess your intention is to advertise for your program but you are achieving quite the opposite…
Better late than never…
Yes, you are correct that both cash and debt increase so the book value of equity stays the same. But remember, we’re trying to measure the change in cash, not the change in equity. I was reading today about how the owners of Full Tilt Poker fraudulently took over $400 million in dividends as a result of increases in player funds. The dividend wouldn’t have been posible without the cash flow to equity resulting from the increase in debt (i.e., the debt provided by the players). Did the book value of equity increase when the players gave the company cash? No. Were the equity owners able to take a dividend because of the increase in debt? Hell yeah.
You know I have the same question…specifically CFA has it as follows:
“Free cash flow to equity is the cash flow available to the company’s holders of common equity after all operating expenses, interest, and principal payments have been paid and necessary investments in working and fixed capital have been made”
Thus I would assume we would subtract principle payments, not add them.
I do get the logic that the debt is available to be distributed as dividends, but this seems to contradict with the theory, at least in my understanding.