How debt affects FCFE?

Hi everyone,

I was hoping someone can please clear this up for me.

If leverage increases, why does it increase FCFE initially? (I understand that later it decreases due to higher interest payments)

Wouldn’t it increase FCFF as well since debt is available to FCFF holders? Thanks!

When you borrow money you could give it all to the shareholders if you want to. Maybe not a brilliant idea, but a possibility.

But in that case wouldn’t FCFF also increase with leverage? Book says no.

Hi, FCFF is not impacted by leverage because this is the CF available to both suppliers of debt and equity, so you don’t want to account for debt here yet. Look at the formulas, it purposely excludes interests. If you included leverage in FCFF, then you wouldn’t be able to see how much is left/available to debt-holders.

In contract, FCFE is the CF available to suppliers of capital only, so there you want to account for debt since shareholders get paid after debt-holders.

Hope it makes sense!