FCFF Approach

Which types of firms are best valued using the free cashflow to the firm (FCFF) approach? A) Firms that are making no significant change to their capital structure. B) Firms that do not pay dividends. C) Firms with significant financial leverage.


QBank says the answer is C. Page 352 of Vol 4 CFA says FCFF or FCFE are preferred when the company is not paying dividends or the dividends differ from the company’s capacity to pay dividends. In fact, Vol 4 of CFA says nothing about financial leverage. Any ideas?

FCFF is hardly affected by financial leverage and FCFE might be slightly affected. Also there is not a red line rule that says that only companies that don’t pay dividends should be using FCFF valuation methodology. Anyone with a controlling perspective can value the firm using FCFF, since they pretty much have discretion over the dividend policy (unlike in DDM - where you take what you get)

I just got the same question in Q-Bank :slight_smile: I think Schweser has the following approach: -> For firms that pay no dividends - it shouldn’t matter which cash flow to use. -> For firms that are changing their capital structure FCFF is preferred Firms with significant financial leverage may have negative FCFE Also From CFAI bottom of page 383 “Leverage changes, such as using mode debt financing, would have some impact because they would increase the interest tax shield (reduce corporate taxes because of the tax deductibility of interest) and reduce the cash flow to equity”.

It still seems strange that the answer is C and not B. Yes, high use of leverage makes a difference between FCFE and FCFF, but the question isn’t only comparing those two - I read it as comparing across all valuation models, and in general FCF models are used from a) control perspective, b) firm has no dividends or dividends unrelated to profits, or c) changes to capital structure You can use other models, like DDM or RI for highly levered firms.

boost Wrote: ------------------------------------------------------- > It still seems strange that the answer is C and > not B. That’s because it is probably only asking between FCFF and FCFE. Is this a concept checker, originally?