FCFF, FCFE and Market Value of Debt

I tried, as an exercise, to reconcile the DCF(FCFF), DCF(FCFE) and Market Value of Debt.

Not only that I failed, it raised additional questions as to NPV concept.

The example is follows.


Investment (Capital) = 500

Debt = 250 (50%), perpetuity bond, market interest rate 9% meaning that market value of debt is 250.

Interest = 250*0.09 = 22.5

Equity = 250 (50%), cost of equity = 12%

Tax = 35%

No capex investment beyond the initial

No Changes in Working capital

No depreciation

Assume no change in probability of default

WACC = 0.5*0.65*0.09 + 0.5*0.12 = 8.925%

FCFF = 50 to perpetuity

FCFE = FCFF – Interest*(1-T) = 50 – 22.5 * 0.65 = 35.375

DCF(FCFF) = FCFF/WACC = 50/0.08925 = 560.224

DCF(FCFE) = FCFE/(cost of equity) = 35.375/0.12 = 294.792

MV(Debt) = DCF(FCFF) – DCF(FCFE) = 560.224 – 294.792 = 265.432

It looks like the debt holders have positive NPV from this debt investment, which cannot be true. At the end of the day, they will get exactly the coupons for perpetuity – and their market value is exactly 250.

So, why is MV (debt) is higher than 250, which was the market value in the first place?

This project creates value (positive NPV). Why is a part of the created value attributed to debt holders? Why does not all created value go to equity holders?

What am I missing?

…s2k walks in…

what about tax shield?

What about tax shield?

I thought, It is taken into account when calculating FCFE.

In any case, if it does create value, it should be attributed to shareholders, not the debt holders. Isn’t it?

not really. it is always debt holder than equity owner. think about the case where there is no debt. you should have 0 interest expense, 0 new borrowings, than difference between FCFF & FCFE should be 0? Am I right?

When Debt = 0, FCFF = FCFE. That is true.

Debt holders do not benefit from tax shields as they are getting paid exactly the same amount regardless of the tax rate.

I don’t understand how the numbers sum up.