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FCFE:
Cash flow (FCFE) = Net income – (1 – debt ratio)* (CAPEX – Depreciation) – (1 – debt ratio)* Changes
in working capital
The discount rate used in this model is the Cost of Equity. In general, the riskier the
investment, the greater is the cost of equity.
FCFF:
Cash flow (FCFF) = EBIT*(1 – tax rate) – (CAPEX – Depreciation) – changes in working capital
The discount rate used is the weighted average cost of capital (WACC) and is calculated as
follows:
WACC = ke*(E/ (D+E)) + kd*(D/(D+E))
Where
E = market value of equity
D = market value of debt
kd = current borrowing rate * (1-t)
t = tax rate
ke = cost of equity (CAPM)
(https://valuationmasterclass.com/wp-content/uploads/2019/10/The-two-FCF-approaches-
should-lead-to-the-same-value-estimate-in-the-case-where-the-company-has-no-debt._.jpg)
Kaplan Schweser (2008) pointed at two cases when FCFF is the best method to be used:
First, FCFF is used for valuing a leveraged company with negative FCFE. Therefore, using FCFF
to value the company’s equity is easier. FCFF is discounted so that the present value of the
total firm value is obtained, and then the market value of debt is subtracted. The outcome of
this calculation is an estimate of the intrinsic value of equity.
Second, FCFF is used for a leveraged company with a changing capital structure. If historical
data are used to forecast FCF growth rates, FCFF growth will reflect fundamentals more
clearly than does FCFE growth. FCFF reflects fluctuating amounts of net borrowing.
Furthermore, in a forward-looking context, the required ROE might be more sensitive to
changes in financial leverage than changes in the WACC, making the use of a constant
discount rate difficult to justify.
Conclusion
When valuing a company, it is important to assess the company and its stage. Based on that,
the most suitable method shall be chosen. Also, an outcome of company comparable analysis
helps to create an overall picture and to value a company the best way possible.
References
Damodaran, A. Discounted Cashflow Valuation: Equity and Firm Models
(http://people.stern.nyu.edu/adamodar/pdfiles/ovhds/dam2ed/dcfveg.pdf)(accessed online
on 25 May 2018).
Kaplan Schweser (2008). Free Cash Flow Valuation. Study Session 12
(http://jsinclaironline.com/free%20cash%20flow%20valuation.pdf) (accessed online on 25 May
2018).
Pinto, J. et al. (2007). Equity Asset Valuation (CFA Institute Investment Series). 2nd Edition
(https://www.amazon.com/Equity-Asset-Valuation-Jerald-Pinto/dp/0470571438/), Kindle
Edition, CFA Institute.
Stotz, A. (2017). Slimwiki (Notes). A. Stotz Investment Research (https://www.astotz.com/).