LM03 Free Cash Flow Valuation 2024 Level II Notes

LM03 Free Cash Flow Valuation

1. Introduction ....................................................................................................................................................... 2
1.1 FCFF and FCFE Valuation Approaches............................................................................................. 2
2. Forecasting Free Cash Flow and Computing FCFF from Net Income ........................................... 5
2.1 Computing FCFF from Net Income .................................................................................................... 5
3. Computing FCFF from the Cash Flow Statement ................................................................................. 7
4. Additional Considerations in Computing FCFF .................................................................................... 8
5. Computing FCFE from FCFF ...................................................................................................................... 10
6. Finding FCFF and FCFE from EBIT or EBITDA .................................................................................. 10
7. FCFF and FCFE on a Uses-of-Free-Cash-Flow Basis......................................................................... 13
8. Forecasting FCFF and FCFE ....................................................................................................................... 14
9. Other Issues in Free Cash Flow Analysis .............................................................................................. 16
10. Free Cash Flow Model Variations ......................................................................................................... 19
10.1 An International Application of the Single-Stage Model ..................................................... 19
10.2 Sensitivity Analysis of FCFF and FCFE Valuations................................................................. 20
11. Two-Stage Free Cash Flow Models ...................................................................................................... 20
12. Three-Stage Free Cash Flow Models ................................................................................................... 21
13. Integrating ESG considerations in Free Cash Flow Models ........................................................ 21
14. Nonoperating Assets and Firm Value ................................................................................................. 22
Summary ............................................................................................................................................................... 23

This document should be read in conjunction with the corresponding learning module in the 2024
Level II CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are
copyright 2023, CFA Institute. Reproduced and republished with permission from CFA Institute. All
rights reserved.

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of
the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are
trademarks owned by CFA Institute.

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R24 Free Cash Flow Valuation 2022 Level II Notes

1. Introduction
In the previous reading, we used dividends as a measure of cash flow for valuation of
companies. In this reading, we will use free cash flow to the firm (FCFF) and free cash flow
to equity (FCFE) as measures of cash flows. While dividends are the cash flows actually
paid to shareholders, free cash flows are the cash flows available for distribution to
shareholders.
Analysts like to use free cash flow valuation models whenever one or more of the following
conditions hold true:
• The company does not pay dividends.
• The company pays dividends, but the dividends paid differ significantly from the
company’s capacity to pay dividends.
• Free cash flows align with profitability within a reasonable forecast period with
which the analyst is comfortable.
• The investor takes a control perspective.
In this reading, we will learn how to calculate FCFF and FCFE, and look at various valuation
models based on discounting of FCFF and FCFE.
1.1 FCFF and FCFE Valuation Approaches
Defining Free Cash Flow
Free cash flow to the firm (FCFF) is the cash flow available to the company’s suppliers of
capital after all operating expenses have been paid and necessary investments in working
capital and fixed capital have been made.
Free cash flow to equity (FCFE) is the cash flow available to the company’s common
stockholders after all operating expenses, interest, and principal payments have been paid
and necessary investments in working and fixed capital have been made.
Valuation approaches:

FCFE represents free cash flow available to shareholders. It is discounted at the cost of
equity to obtain the value of equity.

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R24 Free Cash Flow Valuation 2022 Level II Notes

FCFF, on the other hand, represents free cash flow available to both lenders and
shareholders. It is discounted at the weighted average cost of capital (WACC) to obtain the
value of the total firm. WACC takes into account both cost of equity and cost of debt. By
subtracting the market value of debt from the value of the firm, we can calculate the value
of equity.
Value of equity = Value of the firm – Market value of debt
Instructor’s Note: Ensure that you use the correct discount rates. FCFF should always be
discounted using WACC and FCFE should always be discounted using cost of equity.
The FCFF approach is preferred over the FCFE approach when:
• A company has negative FCFE
• A company has a changing capital structure
Present Value of Free Cash Flow
Let us now look at the formulas for the two approaches. The formulas are similar to the
DDM model covered in the previous reading.
FCFE approach:
The value of equity can be found by discounting FCFE at the required return on equity:
∞
FCFEt
Equity value = ∑
(1 + r)t
t=1

FCFF approach:
The value of the firm can be found by discounting FCFF at the WACC as shown below:
∞
FCFFt
Firm value = ∑
1 + WACCt
t=1

The weighted average cost of capital (WACC) is calculated as:

MV (debt) MV (equity)
WACC = ∗ rd (1 − tax rate) + ∗r
MV (debt) + MV (equity) MV (debt) + MV (equity)
where:
MV (debt) = market value of debt
MV (equity) = market value of equity
Single-Stage (Constant-growth) FCFF and FCFE Models
Constant-Growth FCFF Valuation Model:
The constant-growth FCFF model assumes that FCFF grows at a constant rate g such that
FCFF in any period is equal to FCFF in the previous period multiplied by (1 + g):
FCFFt = FCFFt−1 (1 + g).

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R24 Free Cash Flow Valuation 2022 Level II Notes

The firm value can be calculated using the Gordon growth model:
FCFF1 FCFF0 (1 + g)
Firm value = =
WACC − g WACC − g
Subtracting the market value of debt from the firm value gives the value of equity. Dividing
the total value of equity by the number of outstanding shares gives the value per share.
Example:
(This is based on Example 1 from the curriculum)
The following information is provided for a company.
• FCFF = 700 million
• FCFE = 620 million
• Before tax cost of debt = 5.7%
• Required rate of return of equity = 11.8%
• Target capital structure = 20% debt and 80% equity
• Tax rate = 33.33%
• FCFF is expected to grow at 5% forever
• Market value of outstanding debt = 2.2 billion
• No of outstanding common shares = 200 million
1. Calculate WACC.
2. Calculate equity value using FCFF approach.
3. Calculate value per share.
Solution:
1. WACC = 0.20(5.7%)(1 – 0.3333) + 0.80(11.8%) = 10.2%
FCFF0 (1 + g) 700(1.05)
2. Firm value = = 0.102−0.05 = 14,134.6 million
WACC − g

Equity value = 14,134.6 – 2,200 = 11,934.6 million

3. Value per share = 11,934.6 million / 200 million = 59.67 per share
Constant-Growth FCFE Valuation Model
The constant-growth FCFE model assumes that FCFE grows at a constant rate, g, such that
FCFE in any period is equal to FCFE in the previous period multiplied by (1 + g):
FCFEt = FCFEt−1 (1 + g).
The value of equity can be calculated as:
FCFE1 FCFE0 (1 + g)
Equity value = =
r − g r − g

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R24 Free Cash Flow Valuation 2022 Level II Notes

Instructor’s Note: The growth rate of FCFF and the growth rate of FCFE are usually not the
same.
2. Forecasting Free Cash Flow and Computing FCFF from Net Income
In this section, we will see how to compute FCFF and FCFE from various accounting
measures of income. To keep things simple, we will assume that the firm has only two
sources of capital: debt and common stock.
2.1 Computing FCFF from Net Income
Net income is the bottom line in an income statement. It represents income after
depreciation, amortization, interest expense, and income taxes.
FCFF can be calculated from net income by making the following adjustments:
FCFF = Net income available to common shareholders
Plus: Net noncash charges
Plus: Interest expense * (1 – tax rate)
Less: Investment in fixed capital (FCInv)
Less: Investment in working capital (WCInv)
This equation can also be written as:
FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv
The rationales for these adjustments are:
• Noncash charges reduce reported net income but they don’t actually result in an
outflow of cash. Therefore, they are added back to net income. The largest noncash
charge is usually the depreciation expense. Other noncash charges are covered in
Section 3.3.
• Interest expense, net of tax, is subtracted to arrive at net income. However, interest
is a cash flow available to capital (debt) providers. Hence, the after-tax interest
expense is added back to net income.
• Net investment in fixed capital is subtracted. This represents outflows of cash to
purchase fixed capital necessary to support the firm’s current and future operations.
While calculating the net fixed capital investment we deduct any amount the
company receives in cash by selling any of its long-term assets.
• Investment in working capital is subtracted. Working capital is usually defined as
current assets minus current liabilities. However, for the purposes of calculating
free cash flows, we define working capital to exclude cash, notes payable and
current portion of long-term debt. Cash is excluded because a change in cash is what
we are trying to explain. Notes payables and current portion of long-term debt are

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R24 Free Cash Flow Valuation 2022 Level II Notes

excluded because they are short-term liabilities with explicit interest costs. This
makes them financing items rather than operating items.
Example
(This is based on Example 2 from the curriculum)
The following information is provided for a company. Starting with net income, calculate
FCFF for 2010.
2010 Income Statement (in Thousands)
Earnings before interest, taxes, depreciation, and amortization (EBITDA) 200.00
Depreciation expense 45.00
Operating income 155.00
Interest expense (at 7 percent) 15.68
Income before taxes 139.32
Income taxes (at 30 percent) 41.80
Net income 97.52

2009 and 2010 Balance Sheet (in Thousands)

Years Ending 31 December
2009 2010
Cash 0.00 108.92
Accounts receivable 0.00 100.00
Inventory 60.00 66.00
Current assets 60.00 274.92
Fixed assets 500.00 500.00
Less: Accumulated depreciation 0.00 45.00
Total assets 560.00 729.92

Accounts payable 0.00 50.00

Current portion of long-term debt 0.00 0.00
Current liabilities 0.00 50.00
Long-term debt 224.00 246.40
Common stock 336.00 336.00
Retained earnings 0.00 97.52
Total liabilities and equity 560.00 729.92

Solution:
FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv

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R24 Free Cash Flow Valuation 2022 Level II Notes

FCFF = 97.52 + 45 + 15.68 (1 – 0.3) – 0.00 – 56.00 = 97.50

Here,
Depreciation expense of 45 is the only NCC.
Fixed assets have remained constant at 500. Hence, FCInv = Δ Fixed assets = 0
WC in 2009 = AR + Inv – AP = 0 + 60 – 0 = 60
WC in 2010 = AR + Inv – AP = 100 + 66 – 50 = 116
WCInv = Δ WC = 116 – 60 = 56
3. Computing FCFF from the Cash Flow Statement
Analysts often use cash flow from operations (CFO) as a starting point to compute free cash
flows because CFO is already adjusted for noncash charges like depreciation, as well as for
net investments in working capital.
CFO = NI + NCC – WCInv
Therefore, the equation for calculating FCFF from net income can be simplified as shown
below:
FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv
FCFF = [NI + NCC – WCInv ]+ Int(1 – Tax rate) – FCInv
FCFF = CFO + Int(1 – Tax rate) – FCInv
Note: It is important to understand the treatment of interest expense while calculating
FCFF from CFO. If the interest expense was classified as an operating cash flow, then the
above formula stays the same. However, if the interest expense was classified as a financing
cash flow (applicable only for IFRS) then we do not add back the interest expense; and the
formula changes to: FCFF = CFO – FCInv
The IFRS and US GAAP treatment of interest and dividends is summarized in the table
below.
IFRS US GAAP
Interest received Operating or investing Operating
Interest paid Operating or financing Operating
Dividends received Operating or investing Operating
Dividends paid Operating or financing Financing

Example
(This is based on Example 3 from the curriculum)
The following information is provided for a company reporting under US GAAP. Using CFO
as a starting point calculate FCFF for 2012.

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R24 Free Cash Flow Valuation 2022 Level II Notes

Statement of cash flows: Indirect method (In Thousands)

Year ending 31st Dec 2012
Cash flow from operations
Net income $118.00
Plus: Depreciation 54.45
Increase in accounts receivable (11.00)
Increase in inventory (7.26)
Increase in accounts payable 5.50
Total cash flow from operations 159.69
Cash flow from investing activities
Purchases of PP&E (55.00)
Cash flow from financing activities
Borrowing (repayment) 27.10
Total cash flow 131.80
Beginning cash 228.74
Ending cash 360.54
Notes:
Cash paid for interest ($18.97)
Cash paid for taxes ($50.57)
Tax rate 30%

Solution:
US GAAP classifies interest expense as an operating cash flow. Therefore, no changes are
required to the formula and we can calculate FCFF as:
FCFF = CFO + Int(1 – Tax rate) – FCInv
FCFF = 159.69 + 18.97(1 – 0.30) – 55 = 117.98
4. Additional Considerations in Computing FCFF
Noncash Charges
The following table reproduced from the curriculum shows how several noncash items are
adjusted while calculating FCFF from net income:
Noncash Item Adjustment to NI to Arrive at FCFF
Depreciation Added back
Amortization and impairment of intangibles Added back
Restructuring charges (expense) Added back

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R24 Free Cash Flow Valuation 2022 Level II Notes

Restructuring charges (income resulting Subtracted

from reversal)
Losses Added back
Gains Subtracted
Amortization of long-term bond discounts Added back
Amortization of long-term bond premiums Subtracted
Deferred taxes Added back, but calls for special attention
The rationales for these adjustments are:
• Amortization, like depreciation, is a noncash expense that must be added back to net
income.
• Restructuring charges may be cash expenditures or noncash charges. If the firm
records a restructuring expense/income that is a noncash event such as an asset-
write down, then that amount should be added/subtracted to net income to
determine FCFF. If the restructuring expense is meant to cover future firm expenses,
then forecasts of future FCFF should be reduced by those amounts.
• Gains or losses on sale of long-term assets must be removed. For example, if a firm
records a gain of $30,000 for selling an asset, then the gain is a noncash item and
must be subtracted.
• Amortization of bond discounts and premiums affect net income but do not result in
actual cash flows. If a company has issued bonds, the amortization of bond discounts
should be added back while the amortization of bond premium should be
subtracted.
• Stock option: Granting of stock options does not result in cash outflow, but the
exercise of stock options results in a cash inflow for the firm. This is considered as a
financing cash flow under both IFRS and US GAAP. However, an analyst should
consider the impact of options on the number of shares understanding. When
forecasting FCFF per share, the expected number of shares must be used rather than
the current number of shares outstanding.
• Deferred taxes result from differences in the timing of reporting income and
expenses in the company’s financial statements and the company’s tax return. Over
time, these differences between book income and taxable income should offset each
other and have no effect on the overall cash flows. However, increases in deferred
tax assets that are not expected to reverse should be subtracted from net income.
Similarly, increases in deferred tax liabilities that are not expected to reverse should
be added back to net income.

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R24 Free Cash Flow Valuation 2022 Level II Notes

5. Computing FCFE from FCFF

FCFE is free cash flow available to shareholders, whereas FCFF is free cash flow available to
all capital providers. The cash flows that arise from transactions with debtholders are
deducted from FCFF to arrive at FCFE.
FCFE = Free cash flow to the firm (FCFF)
Less: Interest expense * (1 – Tax rate)
Plus: Net borrowing
This equation can also be written as:
FCFE = FCFF – Int(1 – Tax rate) + Net borrowing
As the above equation shows, FCFE is found by starting from FCFF, subtracting after-tax
interest expenses, and adding net new borrowing. Since interest is paid to debtholders and
is not available to shareholders, the after-tax interest part is subtracted. Net borrowing is
added because this cash flow is available to shareholders. When the debt is paid back, net
borrowing can be negative.
Calculating FCFE from net income
We can adjust the “FCFF from net income” formula to get a formula for “FCFE from net
income” as shown below:
FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv
FCFE = [NI + NCC + Int(1 – Tax rate) – FCInv – WCInv] – Int(1 – Tax rate) + Net
borrowing
FCFE = NI + NCC – FCInv – WCInv + Net borrowing
Calculating FCFE from CFO
Similarly, we can adjust the “FCFF from CFO” formula to get a formula for “FCFE from CFO”
as shown below:
FCFF = CFO + Int(1 – Tax rate) – FCInv
FCFE = [CFO + Int(1 – Tax rate) – FCInv] – Int(1 – Tax rate) + Net borrowing
FCFE = CFO – FCInv + Net borrowing
6. Finding FCFF and FCFE from EBIT or EBITDA
In the previous sections, we started from the last line item on the income statement and
made adjustments to it. Now, we go up the income statement and derive FCFF from other
income statement items such as EBIT or EBITDA.

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R24 Free Cash Flow Valuation 2022 Level II Notes

Calculating FCFF from EBIT

We start with the “FCFF from net income” formula and assume that depreciation is the only
noncash charge.
FCFF = NI + Dep + Int(1 – Tax rate) – FCInv – WCInv
Net income (NI) can be expressed as
NI = (EBIT – Int)(1 – Tax rate) = EBIT(1 – Tax rate) – Int(1 – Tax rate)
Substituting this expression for NI in the equation for FCFF, we have:
FCFF = EBIT(1 – Tax rate) + Dep – FCInv – WCInv
Some important points to note about this formula are:
• EBIT is before interest and taxes.
• We don’t adjust for interest since we are calculating cash flows to all providers of
capital.
• However, we do have to adjust for taxes by calculating after tax EBIT.
• Depreciation is added back because it was subtracted to get EBIT.
• Adjustments for FCInv and WCInv are required as before.
Calculating FCFF from EBITDA
We start with the “FCFF from net income” formula and assume that depreciation is the only
noncash charge.
FCFF = NI + Dep + Int(1 – Tax rate) – FCInv – WCInv
Net income can be expressed as
NI = (EBITDA – Dep – Int)(1 – Tax rate) = EBITDA(1 – Tax rate) – Dep(1 – Tax rate) –
Int(1 – Tax rate)
Substituting this expression for NI in the equation for FCFF, we have:
FCFF = EBITDA(1 – Tax rate) + Dep(Tax rate) – FCInv – WCInv
Some important points to note about this formula are:
• EBITDA is before interest, taxes and depreciation.
• We don’t adjust for interest.
• We adjust for taxes by calculating after tax EBITDA.
• Only the depreciation tax shield (Dep x Tax rate) is added because the company
saves on taxes by showing depreciation as an expense, which adds to its cash flows.
• Adjustments for FCInv and WCInv are required as before.
Example
(This is based on Example 5 from the curriculum)

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R24 Free Cash Flow Valuation 2022 Level II Notes

The following information is provided for a company.

Balance Sheet (in US$ Millions)
Year ended 31st Dec 2011 2012
Cash 190 200
Accounts receivable 560 600
Inventory 410 440
Current assets 1,160 1,240
Fixed assets 2,200 2,600
Less accum. depreciation (900) (1,200)
Total assets 2,460 2,640
Accounts payable 285 300
Notes payable 200 250
Accrued expenses 140 150
Total current liabilities 625 700
Long-term debt 865 890
Common stock 100 100
Additional paid-in capital 200 200
Retained earnings 670 750
Total liabilities & equity 2,460 2,640

Income Statement (in US$ Millions)

Year ended 31st Dec 2012
Total revenues 3,000
Operating costs 2,200
EBITDA 800
Depreciation 300
EBIT 500
Interest expense 100
EBT 400
Taxes (@40%) 160
Net Income 240
Dividends 160

Calculate FCFF and FCFE:

1. Starting with EBIT.

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R24 Free Cash Flow Valuation 2022 Level II Notes

2. Starting with EBITDA.

Solution:
We first calculate FCInv, WCInv and net borrowing

FCInv = Δ Fixed assets = 2,600 – 2,200 = 400

WCInv = Δ WC (Ignoring cash and short-term debt)

NWCBeg = (560+410) – (285+140) = 545
NWCEnd = (600+440) – (300+150) = 590
WCInv = 590 – 545 = 45

Net borrowing: Because notes payable increased by $50 million ($250 million − $200
million) and long-term debt increased by $25 million ($890 million − $865 million), net
borrowing is $75 million

1. FCFF = EBIT(1 − Tax rate) + Dep − FCInv − WCInv

FCFF = 500(1 − 0.40) + 300 − 400 − 45 = $155 million

FCFE = FCFF − Int(1 − Tax rate) + Net borrowing

FCFE = 155 − 100(1 − 0.40) + 75 = $170 million

2. FCFF = EBITDA(1 − Tax rate) + Dep(Tax rate) − FCInv − WCInv

FCFF = 800(1 − 0.40) + 300(0.40) − 400 − 45 = $155 million

FCFE = FCFF − Int(1 − Tax rate) + Net borrowing

FCFE = 155 − 100(1 − 0.40) + 75 = $170 million
7. FCFF and FCFE on a Uses-of-Free-Cash-Flow Basis
So far, we used the sources of cash flow such as net income or cash flow from operations as
starting points for calculating FCFF and FCFE. We will now take a slightly different
approach by examining the uses of free cash flow. For instance, free cash flow to equity may
be used to pay out dividends, acquire other companies, and repurchase shares and so on.
Analyzing free cash flow on a uses basis serves as a consistency check on the sources
calculation. The uses of FCFF must equal the sources of FCFF.
Uses of FCFF = Δ cash balance + net payments to debt providers + net payments to
equity holders
where:
Δ cash balance = cash flow from operations ± cash from financing activities ± cash from
investing activities.
Net payments to debt providers = Int (1 - Tax rate) + debt repayments – debt issuance

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R24 Free Cash Flow Valuation 2022 Level II Notes

Net payments to equity holders = dividends paid + share repurchases – share issuances
8. Forecasting FCFF and FCFE
There are two approaches to forecast FCFF and FCFE:
• Assume that the free cash flows will grow at a constant rate forever.
• Forecast the individual components of the free cash flow separately.
Constant growth: This approach assumes that the free cash flows (FCFF and FCFE) will
grow at a constant rate forever. The simplest assumption is to use the historical growth
rate if the relationships between free cash flow and the fundamental factors are expected to
continue.
For example, assume that the historical growth rate is 15 percent a year and last year’s
FCFF was $155 million. If FCFF continues to grow at historic levels, then the next year
estimate for FCFF will be 155 x 1.15 = $178.25 million.
Forecast individual components: The second approach is to forecast the individual
components of free cash flow, such as EBIT, net noncash charges, investment in fixed
capital, and investment in working capital separately.
We look at a simple sales-based forecasting method for FCFF and FCFE based on the
following major assumption:
“Investment in fixed capital in excess of depreciation (FCInv – Dep) and investment in
working capital (WCInv) both bear a constant relationship to increases in sales.”
In addition, for FCFE forecasting, we assume that the capital structure represented by the
debt ratio (DR)—debt as a percentage of debt plus equity—is constant. Under this
assumption, DR indicates the percentage of (FCInv – Dep) and WCInv that will be financed
with debt. We also assume that depreciation is the only non-cash charge. This method does
not work well when there are other noncash charges.
The steps to forecast FCFF and FCFE are:
• Forecast the increase in sales using growth rate estimates
• Forecast the after-tax operating margin EBIT (1- tax rate) for FCFF and net profit
margin for FCFE.
• Estimate the incremental FCInv in relation to sales increases using the formula:
(Capital expenditure − Depreciation expense)/(Increase in sales)
• Estimate the incremental WCInv in relation to sales increases using the formula:
(Increase in working capital)/(Increase in sales)
• Estimate DR
FCFF can be estimated as:
FCFF = EBIT (1 – tax rate) –Δ FCInv – ΔWCInv
Assuming the DR is maintained, FCFE can be estimated as:

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R24 Free Cash Flow Valuation 2022 Level II Notes

FCFE = NI – (1 – DR) (FCinv – Dep) – (1 – DR) (WCInv)

Example:
(This is based on Example 8 from the curriculum)
The following information is provided for a company:
• Sales in 2012 were $3,000 million and are expected to increase by 10% in 2013
• Sales grew by $300 million from 2011 to 2012
• Working capital grew by $45 million from 2011 to 2012
• Historical EBIT margin of 16.67% will be maintained
• 2012 statement of cash flows show capital expenditures of $400 million and
depreciation of $300 million.
• Tax rate is 40%
Forecast FCFF for 2013.
Solution:
Incremental fixed capital investment in 2012 was:
Capital expenditures − Depreciation expense 400 − 300
= = 33.33%
Increase in sales 300
Incremental working capital investment in 2012 was:
Increase in working capital 45
= = 15%
Increase in sales 300
So, for every $100 increase in sales, the company invests $33.33 in new equipment in
addition to replacement of depreciated equipment and $15 in working capital.
FCFF for 2013 can be forecasted as:
FCFF = EBIT (1 – tax rate) –Δ FCInv – ΔWCInv
Sales $3,300 Up 10 percent
EBIT 550 16.67 percent of sales
EBIT(1 – Tax rate) 330 Adjusted for 40 percent tax rate
Incremental FC (100) 33.33 percent of sales increase
Incremental WC (45) 15 percent of sales increase
FCFF $185

Example
(This is based on Example 10 from the curriculum)
For the same company from the previous example, the following additional information is
provided:
• Profit margin will remain at 8%

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• the company will finance incremental fixed and working capital investments with 50%
debt, the target DR
Forecast FCFE for 2013.
Solution:
Sales $3,300 Up 10 percent
NI 264 8.0 percent of sales
Incremental FC (100) 33.33 percent of sales increase
Incremental WC (45) 15 percent of sales increase

FCFE for 2013 can be forecasted as:

FCFE = NI – (1 – DR) (FCinv – Dep) – (1 – DR) (WCInv)
FCFE = 264 – (1 – 0.5) (100) – (1 – 0.5) (45) = $191.50 million
9. Other Issues in Free Cash Flow Analysis
Analysts should be aware of the following issues when forecasting FCFF and FCFE:
Adjustments to CFO: Analysts should adjust the reported CFO number by removing the
impact of financing and/or investing activities. The resulting analyst-adjusted CFO should
be the starting point for free cash flow calculations.
Free cash flow versus dividends and other earnings components: Analysts prefer FCFE
over dividend discount models because:
• Some companies pay no or few dividends.
• Dividend payments are at the discretion of the company’s board of directors, and
may not be indicative of the company’s long-term profitability.
• Free cash flow to equity is the amount available for distribution without impairing a
company’s value.
• FCFE is an appropriate cash flow measure when a company is a target for a
takeover.
Effect of dividends, share repurchases and leverage on FCFF and FCFE:
Dividends, share repurchases, and leverage do not affect FCFF and FCFE to a great extent.
In the formulas for FCFF and FCFE, dividends and share repurchases are absent because
these are the uses of cash flows, and not what is available to the shareholders. Similarly,
with stock issuance, investors are putting in money into the firm. It does not reflect what is
available to the equity holders.
An increase in leverage increases the tax savings for FCFF. It affects FCFE in two ways:
increases FCFE by the amount of debt issued and reduces the cash flow to equity by the
after-tax interest expense, i.e. interest payments to debtholders in the future.

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R24 Free Cash Flow Valuation 2022 Level II Notes

FCFF/FCFE vs. EBITDA as a measure of cash flow

FCFF and FCFE are measures of cash flow designed for the valuation of the firm or its
equity. The curriculum states that, “because using free cash flow analysis requires
considerable care and understanding, some practitioners erroneously use earnings
components such as NI, EBIT, EBITDA, or CFO in a discounted cash flow valuation. Such
mistakes may lead the practitioner to systematically overestimate or underestimate value.”
A common shortcut is to use EBITDA as a proxy for FCFF. However, EBITDA is a poor proxy
for FCFF because it does not account for depreciation, investments in fixed capital and
working capital, and cash outflow due to taxes. This is evident when we look at the
following equation:
FCFF = EBITDA (1 – Tax rate) + Dep (Tax rate) – FCInv – WCInv
Similarly, net income is a poor proxy for FCFE because it does not account for fixed capital,
working capital investment and net borrowings. This is evident when we look at the
following equation:
FCFE = NI + NCC – FCInv – WCInv + Net borrowing
Free cash flow and complicated capital structures
In our discussion so far, we assumed that the company has a simple capital structure with
two sources of capital: debt and equity. However, some companies may have additional
capital sources, such as preferred stocks.
The following example demonstrates how to calculate WACC, FCFE, and FCFF when the
company has preferred stock.
Example
(This is based on Example 12 from the curriculum)
A company uses bond, preferred stock, and common stock financing. The market value of
each of these sources of financing and the before-tax required rates of return for each are
given below:
Market Value (in $ Millions) Required Return (%)
Bonds 400 8.0
Preferred stock 100 8.0
Common stock 500 12.0
Total 1,000

Other financial information (in $ millions):

• Net income available to common shareholders = $110.
• Interest expenses = $32.
• Preferred dividends = $8.

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R24 Free Cash Flow Valuation 2022 Level II Notes

• Depreciation = $40.
• Investment in fixed capital = $70.
• Investment in working capital = $20.
• Net borrowing = $25.
• Tax rate = 30 percent.
• Stable growth rate of FCFF = 4.0 percent.
• Stable growth rate of FCFE = 5.4 percent.

1. Calculate the company’s WACC.

2. Calculate the current value of FCFF.
3. Based on forecasted Year 1 FCFF, what is the total value of the company and the value
of its equity?
4. Calculate the current value of FCFE.
5. Based on forecasted Year 1 FCFE, what is the value of equity?
Solution to 1:
400 100 500
WACC = 8%(1 − 0.03) + 8% + 12% = 9.04%
1,000 1,000 1,000
Solution to 2:
If the company did not issue preferred stock, FCFF would be
FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv
If preferred stock dividends have been paid (and net income is income available to
common shareholders), the preferred dividends must be added back just as after-tax
interest expenses are. The modified equation (including preferred dividends) for FCFF is
FCFF = NI + NCC + Int(1 – Tax rate) + Preferred dividends – FCInv – WCInv
FCFF = 110 + 40 + 32(1 – 0.30) + 8 – 70 – 20 = $90.4 million
Solution to 3:
FCFF1 90.4(1.04)
Firm value = = = $1,865.40 million
WACC − g 0.0904 − 0.04
The value of (common) equity is the total value of the company minus the value of debt and
preferred stock:
Equity = 1,865.40 – 400 – 100 = $1,365.40 million
Solution to 4:
With no preferred stock, FCFE is
FCFE = NI + NCC – FCInv – WCInv + Net borrowing

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R24 Free Cash Flow Valuation 2022 Level II Notes

If the company has preferred stock, the FCFE equation is essentially the same. Net
borrowing in this case is the total of new debt borrowing and net issuances of new
preferred stock.
FCFE = 110 + 40 – 70 – 20 + 25 = $85 million
Solution to 5:
FCFE1 85(1.054)
Equity value = = = $1,357.42 million
r − g 0.12 − 0.054
10. Free Cash Flow Model Variations
10.1 An International Application of the Single-Stage Model
When valuing stocks in countries with high or variable inflation, analysts often use real
cash flows and discount at real discount rates. Given below is one way of coming up with a
real required rate of return for stocks from a particular country. We start with country
return and make adjustments to for the stock’s industry, size, and leverage using a build-up
model.

Country return (real) x.xx %

+ / – Industry adjustment x.xx %
+ / – Size adjustment x.xx %
+ / – Leverage adjustment x.xx %
Required rate of return (real) x.xx %
Using real growth rate values, the formula for the value of a stock is stated as:
FCFE0 (1 + g real )
V0 =
rreal − g real
where:
g real = real growth rate
rreal = real discount rate
Example:
(This is based on Example 13 from the curriculum)
The following information is provided for a company operating in a high inflation country.
• FCFE per share for the year just ended = 7.05
• Real country return = 7.3%. Adjustments to the country return for this company are an
industry adjustment of + 0.80%, a size adjustment of –0.33 %, and a leverage
adjustment of –0.12 %
• Long term real growth rate of the country = 3.0%. The real growth rate for the company
is expected to be about 0.5 percent below the country rate

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R24 Free Cash Flow Valuation 2022 Level II Notes

Calculate the value of each share.

Solution:
The company’s real required rate of return is:
Country return (real) 7.30%
Industry adjustment + 0.80%
Size adjustment – 0.33%
Leverage adjustment – 0.12%
Required rate of return 7.65%

The real growth rate of FCFE is expected to be 2.5 percent (3.0 percent − 0.5 percent), so
the value of one share is:
FCFE0 (1 + g real ) 7.05(1.025)
V0 = = = 140.32
rreal − g real 0.0765 − 0.025
10.2 Sensitivity Analysis of FCFF and FCFE Valuations
The value of a firm or equity depends on estimates for future growth rates, duration of
growth, and base-year values for FCFF and FCFE. Growth rate and duration of growth
depend on the growth phase of the company and the profitability of the industry.
Analysts perform a sensitivity analysis to examine how valuation changes with each of
these inputs. Some input variables have a much larger impact on stock valuation than
others.
11. Two-Stage Free Cash Flow Models
There are two versions of two-stage free cash flow models. In the first version, we assume
that the growth rate is constant in stage 1 and it declines to a sustainable rate at the
beginning of stage 2. The transition from growth rate in stage 1 to the sustainable growth
rate in stage 2 is abrupt.
The general expression for the two-stage FCFF and FCFE valuation models are as follows:
n
FCFFt FCFFn+1 1
Firm value = ∑ + ∗
(1 + WACC)t WACC − g (1 + WACC)n
t=1
n
FCFEt FCFEn+1 1
Equity value = ∑ t
+ ∗
(1 + r) r−g (1 + r)n
t=1

The formulas indicate that the firm or equity value comprises two terms:
• The present value of cash flow stream during the initial growth period at a higher
growth rate.

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R24 Free Cash Flow Valuation 2022 Level II Notes

• The present value of the cash flows growing in perpetuity at the long-term
sustainable growth rate.
Since the terminal value constitutes a large portion of the value of the stock or the firm, it is
critical to estimate it accurately.
In the second version, the rapid growth rate in stage 1 declines gradually over time to a
steady rate in stage 2. For instance, a highly profitable company may have low or negative
free cash flows. When profitability slows because of increased competition, investment
slows and FCFE increases. The value of the company depends on these free cash flows,
which increase after the initial high growth period.
Instructor’s Note: The calculations for these models are similar to the two-stage DDM
models covered in the previous reading.
12. Three-Stage Free Cash Flow Models
The three-stage models are an extension of the two-stage models. These models are
appropriate when cash flow streams fluctuate from year to year. There are two versions of
three-stage FCF models.
In one version, we assume a constant growth rate in each of the three stages. The growth
rates could be for sales, profits, and investments in fixed and working capital; external
financing could be a function of the level of sales or change in sales. A simpler model would
apply the growth rate to FCFF or FCFE.
A second common model is a three-stage model with constant growth rates in stages 1 and
3 and a declining growth rate in stage 2. Again, the growth rates could be applied to sales or
to FCFF or FCFE.
Instructor’s Note: The calculations for these models are similar to the three-stage DDM
models covered in the previous reading.
13. Integrating ESG considerations in Free Cash Flow Models
Incorporating environmental, social, and governance (ESG) considerations in valuation
models can have a significant impact on company valuation. ESG factors can be quantitative
or qualitative.
Quantitative ESG information is straight-forward to incorporate in a valuation model, for
example, it can be easy to estimate the fine resulting from environmental pollution.
In contrast, qualitative ESG information is more difficult to incorporate. One way of doing
this is to adjust the cost of equity by adding a risk premium. This method however, requires
judgment on part of the analyst to determine the amount of the risk premium.

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R24 Free Cash Flow Valuation 2022 Level II Notes

14. Nonoperating Assets and Firm Value

In free cash valuation, the focus is on the value of assets needed to generate operating cash
flows. If a company has significant nonoperating assets, such as excess cash, excess
marketable securities, or land held for investment, then the value of the firm is calculated
as the value of its operating assets (e.g., as estimated by FCFF valuation) plus the value of
its nonoperating assets:
Value of firm = Value of operating assets + Values of nonoperating assets

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R24 Free Cash Flow Valuation 2022 Level II Notes

Summary
LO: Compare the free cash flow to the firm (FCFF) and free cash flow to equity (FCFE)
approaches to valuation.
Free cash flow to the firm (FCFF) is the cash flow available to the company’s suppliers of
capital after all operating expenses have been paid and necessary investments in working
capital and fixed capital have been made. It is discounted at the weighted average cost of
capital (WACC), to obtain the value of the total firm. WACC takes into account both cost of
equity and cost of debt. By subtracting the market value of debt from the value of the firm,
we can calculate the value of equity.
Value of equity = Value of the firm – Market value of debt
Free cash flow to equity (FCFE) is the cash flow available to the company’s common
stockholders after all operating expenses, interest, and principal payments have been paid
and necessary investments in working and fixed capital have been made. It is discounted at
the cost of equity to obtain the value of equity.
FCFF is preferred over FCFE for a levered company with negative FCFE, or with changing
capital structure.
LO: Explain the ownership perspective implicit in the FCFE approach.
Analysts like to use free cash flow as the return (either FCFF or FCFE) whenever one or
more of the following conditions hold true:
• The company does not pay dividends.
• The company pays dividends, but the dividends paid differ significantly from the
company’s capacity to pay dividends.
• Free cash flows align with profitability within a reasonable forecast period with
which the analyst is comfortable.
• The investor takes a control perspective.
LO: Explain the appropriate adjustments to net income, earnings before interest and
taxes (EBIT), earnings before interest, taxes, depreciation, and amortization
(EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE.
LO: Calculate FCFF and FCFE.
FCFF can be calculated as:
FCFF = NI + NCC + Int (1 − tax rate) − FCInv − WCInv
FCFF = CFO + Int (1 – Tax rate) - FCInv
FCFF = EBIT (1 – Tax rate) + Dep – FCInv – WCInv
FCFF = EBITDA(1 – Tax rate) + Dep(Tax rate) – FCInv – WCInv

FCFE can be calculated as:

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R24 Free Cash Flow Valuation 2022 Level II Notes

FCFE = FCFF – Int(1 – Tax rate) + Net borrowing

FCFE = NI + NCC – FCInv – WcInv + Net borrowing
FCFE = CFO – FCInv + Net borrowing
LO: Describe approaches for forecasting FCFF and FCFE.
There are two approaches to forecast FCFF and FCFE:
• Assume that that the free cash flows will grow at a constant rate forever.
• Forecast the individual components of the free cash flow separately.
Under the second approach,
FCFF can be estimated as:
FCFF = EBIT (1 – tax rate) –Δ FCInv – ΔWCInv
Assuming the DR is maintained, FCFE can be estimated as:
FCFE = NI – (1 – DR) (FCinv – Dep) – (1 – DR) (WCInv)
LO: Compare the FCFE model and the dividend discount models.
Analysts prefer the FCFE model over dividend discount model for the following reasons:
• Some companies pay no or less dividends.
• Dividends are substantially lower or more than their free cash flow.
• Free cash flow to equity is the amount available for distribution without impairing a
company’s value.
• FCFE is an appropriate cash flow measure when a company is a target for a
takeover.
LO: Explain how dividends, share repurchases, share issues, and changes in leverage
may affect future FCFF and FCFE.
Dividends, share repurchases, and share issues do not affect FCFEE and FCFE.
Increase in leverage increases the tax savings for FCFF. It affects FCFE in two ways:
increases FCFE by the amount of debt issued and reduces the cash flow to equity by the
after-tax interest expense in the future i.e. interest payments to debtholders in the future.
LO: Evaluate the use of net income and EBITDA as proxies for cash flow in valuation.
EBITDA is a poor proxy for cash flow because it does not account for depreciation,
investments in fixed capital and working capital, and cash outflow due to taxes. This is
evident when we look at the following equation:
FCFF = EBITDA (1 – Tax rate) + Dep (Tax rate) – FCInv – WCInv

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R24 Free Cash Flow Valuation 2022 Level II Notes

Similarly, net income is a poor proxy for FCFE because it does not account for fixed capital,
working capital investment and net borrowings. This is evident when we look at the
following equation:
FCFE = NI + NCC – FCInv – WCInv + Net borrowing
LO: Explain the single-stage (stable-growth), two-stage, and three-stage FCFF and
FCFE models, and justify the selection of the appropriate model given a company’s
characteristics.
A simpler version of two-stage model assumes a constant growth rate in each stage with
the transition from stage 1 to stage 2 being abrupt. A second version assumes declining
growth in stage 1 followed by a long-run sustainable growth rate in stage 2.
Three-stage growth models are appropriate when cash flow stream fluctuates from year to
year.
LO: Estimate a company’s value using the appropriate free cash flow model(s).
Expressions for FCFF and FCFE using the single-stage model:
FCFF1 FCFF0 (1 + g)
Firm value = =
WACC − g WACC − g
FCFE1 FCFE0 (1 + g)
Equity value = =
r − g r − g
Expressions for FCFF and FCFE using the multi-stage models:
n
FCFFt FCFFn+1 1
Firm value = ∑ + ∗
(1 + WACC)t WACC − g (1 + WACC)n
t=1
n
FCFEt FCFEn+1 1
Equity value = ∑ t
+ ∗
(1 + r) r−g (1 + r)n
t=1

LO: Explain the use of sensitivity analysis in FCFF and FCFE valuations.
Since the models are sensitive to inputs such as growth rates, duration of the growth rates,
and base values of FCFF/FCFE, analysts must perform a sensitivity analysis to examine how
the value of a firm changes with each of these inputs.
LO: Describe approaches for calculating the terminal value in a multistage valuation
model.
The terminal value is calculated using two ways as seen in DDM: calculate the present value
of the terminal value, or multiply the forecasted multiple such as EPS with the estimated
value of the fundamental such as earnings.

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R24 Free Cash Flow Valuation 2022 Level II Notes

LO: Evaluate whether a stock is overvalued, fairly valued, or undervalued based on a

free cash flow valuation model.
If the per share value of a stock based on FCFE is greater than its current price, then the
stock is undervalued. Similarly, if the per share value of a stock based on FCFE is lesser
than its current price, then the stock is overvalued.

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