Clevency
- The two formulas side by side
- FCFF vs FCFE: head-to-head
- Worked numerical example (mid-cap manufacturer)
- Where to find each input on the 3 financial statements
- When to use FCFF vs FCFE
- Common CFA exam traps
- Sensitivity: what happens when leverage changes
- CFA exam coverage: which LOS, which level
- Frequently asked questions
The two formulas side by side
FCFF = EBIT × (1 − t) + D&A − CapEx − ΔNWC
Where t is the tax rate, D&A is depreciation and amortisation, CapEx is capital expenditures, and ΔNWC is the change in non-cash working capital.
Equivalent starting from Net Income:
FCFF = NI + Int × (1 − t) + D&A − CapEx − ΔNWC
Starting from Cash Flow from Operations:
FCFF = CFO + Int × (1 − t) − CapEx
And:
FCFE = FCFF − Int × (1 − t) + Net Borrowing
Where Net Borrowing = new debt issued − debt repaid. Equivalent:
FCFE = CFO − CapEx + Net Borrowing
FCFF vs FCFE: head-to-head
| Dimension | FCFF | FCFE |
|---|---|---|
| Claimants | All capital providers (debt + equity) | Equity holders only |
| Discount rate | WACC | Cost of equity (Ke) |
| Value produced | Enterprise value → subtract debt to get equity | Equity value directly |
| Interest expense | Added back (after-tax) | Not added back |
| Net borrowing | Not included | Added |
| Best for | Firms with changing or complex capital structure | Firms with stable leverage; equity-only perspective |
| Can be negative? | Rarely — only for severely cash-burning firms | Yes, especially during heavy debt repayment or capex cycles |
Worked numerical example (mid-cap manufacturer)
Assume the following for a mid-cap industrial company, in USD millions:
| Line item | Value |
|---|---|
| Revenue | 500 |
| Operating expenses | 380 |
| Depreciation & amortisation | 40 |
| EBIT | 80 |
| Interest expense | 15 |
| Taxable income | 65 |
| Tax @ 25% | 16.25 |
| Net income | 48.75 |
| CapEx | 60 |
| ΔNWC (increase) | 10 |
| Net borrowing (new debt − repaid) | 20 |
Step 1 — Compute FCFF from EBIT:
FCFF = EBIT × (1 − t) + D&A − CapEx − ΔNWC
FCFF = 80 × 0.75 + 40 − 60 − 10
FCFF = 60 + 40 − 60 − 10 = USD 30 million
Step 2 — Compute FCFE from FCFF:
FCFE = FCFF − Int × (1 − t) + Net Borrowing
FCFE = 30 − 15 × 0.75 + 20
FCFE = 30 − 11.25 + 20 = USD 38.75 million
Step 3 — Check via Net Income:
FCFE = NI + D&A − CapEx − ΔNWC + Net Borrowing
FCFE = 48.75 + 40 − 60 − 10 + 20 = USD 38.75 million ✓
Step 4 — Discount to value (illustrative):
If WACC = 8% and FCFF grows at 3% in perpetuity:
Enterprise value = 30 × 1.03 / (0.08 − 0.03) = 30.9 / 0.05 = USD 618 million
If cost of equity Ke = 11% and FCFE grows at 3% in perpetuity:
Equity value = 38.75 × 1.03 / (0.11 − 0.03) = 39.9 / 0.08 = USD 499 million
Where to find each input on the 3 financial statements
| Input | Statement | Line item |
|---|---|---|
| EBIT | Income statement | Operating income (before interest and tax) |
| Net income | Income statement | Bottom line, after tax |
| Interest expense | Income statement | Below operating income |
| Tax rate | Income statement or footnotes | Effective tax rate |
| Depreciation & amortisation | Cash flow statement (operating) | Added back to NI in CFO section |
| CFO | Cash flow statement | Cash flow from operations total |
| CapEx | Cash flow statement (investing) | Purchases of PP&E |
| ΔNWC | Cash flow statement or compute from balance sheet | Changes in receivables, inventory, payables |
| Net borrowing | Cash flow statement (financing) | Debt issued minus debt repaid |
When to use FCFF vs FCFE
Use FCFF when:
- The firm has significantly changing leverage (M&A, LBO, deleveraging)
- FCFE is negative or volatile
- You want enterprise value, not direct equity value
- You are valuing a highly levered firm where the cost of equity is unstable
Use FCFE when:
- The firm has stable, mature capital structure
- You want equity value directly, without the Enterprise - Debt step
- You are explicitly taking an equity holder's perspective
- Dividend policy and buybacks are being modelled from available equity cash
Common CFA exam traps
Trap 1 — mismatching cash flow and discount rate. Discounting FCFF at the cost of equity, or FCFE at WACC, is the most-common wrong answer deliberately placed as a distractor. FCFF goes with WACC; FCFE goes with Ke. Full stop.
Trap 2 — forgetting to add interest back after tax when going from NI to FCFF. The adjustment is Int × (1 − t), not Int alone. Candidates who forget the tax shield consistently undershoot FCFF.
Trap 3 — net borrowing with the wrong sign. Net borrowing is debt issued minus debt repaid. If the firm is repaying debt (net borrowing negative), FCFE is reduced, not increased. Exam questions deliberately present a mid-sized debt repayment to catch sign errors.
Trap 4 — using book interest rate instead of cost of debt. For WACC, you use the market cost of debt (yield on existing debt or new-issue cost), not the historic coupon.
Sensitivity: what happens when leverage changes
Keeping the mid-cap manufacturer example but assume the firm now repays USD 30 million of debt (net borrowing = −30):
FCFE = 30 − 11.25 + (−30) = USD −11.25 million
FCFE flips to negative despite stable operating performance. This is why FCFF is often preferred for firms in deleveraging phases: FCFF stays at USD 30 million regardless, while FCFE whipsaws with capital-structure moves.
Conversely, a firm raising debt sees FCFE boosted — but this is not free cash flow in a sustainable sense. CFA exam vignettes often introduce a one-time debt raise to test whether candidates will inflate equity value by projecting the elevated FCFE forward.
CFA exam coverage: which LOS, which level
FCFF and FCFE are introduced at Level 1 (reading on cash flow analysis under FSA) and tested in depth at Level 2 under Equity Valuation. The Level 2 vignettes typically give you three financial statements and ask you to compute FCFF or FCFE and then value the firm or equity under a two-stage growth model. Expect at least one FCFF/FCFE vignette on any Level 2 Equity session.
Frequently asked questions
What happens to FCFE if leverage changes?
FCFE moves directly with net borrowing. New debt issuance boosts FCFE in that year; debt repayment reduces it. FCFF is immune to the capital structure change — which is why FCFF is preferred for firms with changing leverage.
Which is more commonly used in practice?
FCFF is more common for enterprise-level valuation (M&A, LBO modelling, firm-wide DCF). FCFE is more common for stable-leverage mature companies and dividend policy analysis. Both are standard tools.
Can FCFE be negative?
Yes, routinely. Heavy capex, large debt repayments, or working capital expansion all drive FCFE negative in individual years. A persistently negative FCFE is a warning sign; a one-off is normal.
Can FCFF be negative?
Only for firms burning cash at the operating level — early-stage growth firms, deeply cyclical downturns, or firms making outsized acquisitions. Mature firms very rarely show negative FCFF.
Should D&A be added for FCFF or only non-cash D&A?
All D&A on the cash flow statement is non-cash by definition — it was already deducted in computing EBIT, so adding it back converts the earnings-based measure to a cash-based measure. There is no 'cash D&A' to exclude.
Why don't we add back amortisation of debt discount?
You do, if material. Formally, FCFF adds back all non-cash charges in EBIT, including amortisation of debt discount, impairments, and stock-based compensation. For CFA exam purposes, the stylised formula uses D&A as a catch-all.
Does FCFF include interest income on cash balances?
Yes, interest income is part of operating earnings in CFA conventions. If the firm has significant interest income from excess cash, it flows through EBIT and into FCFF.