FCFF vs FCFE: What's the Difference?

Free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) are two of the most important metrics used in financial modeling. Both metrics measure the amount of cash that is available to a company's shareholders and creditors, but there is a key difference between the two.

FCFF measures the cash flow that is available to all capital providers, including debt holders and equity holders.

FCFE, on the other hand, measures the cash flow that is available to equity holders only.

How to Calculate FCFF and FCFE

One of the most common ways to derive FCFF is by adding tax adjusted interest expense (TAIE = Interest Expense * (1 - Tax Rate) to the companies operating cash flow (OCF), then subtracting capital expenditures (capex). The formula would look something like this:

FCFF = OCF + Tax-Adjusted Interest Expense (TAIE) - Capex

FCFE is calculated by subtracting capex from operating cash flows, and then adding back debt issuance.

FCFE = OCF - Capex + Net Debt Issuance

Why are FCFF and FCFE important?

FCFF and FCFE are important metrics for investors because they measure a company's ability to generate cash flow that can be used to pay dividends, invest in new growth opportunities, or repay debt.

FCFF is particularly important for creditors, as it is a measure of how much cash a company has available to service its debt obligations. FCFE is important for equity investors, as it is a measure of how much cash a company has available to return to its shareholders in the form of dividends or share buybacks.

How to use FCFF and FCFE

FCFF and FCFE can be used in a number of ways, including:

• Company valuation: FCFF and FCFE can be used to value companies using discounted cash flow (DCF) analysis. DCF analysis is a valuation method that estimates the value of a company based on the present value of its future cash flows.
• Credit analysis: FCFF can be used to assess a company's creditworthiness and ability to repay its debt obligations.
• Dividend sustainability: FCFE can be used to assess a company's ability to sustain its dividend payments.
• Investment analysis: FCFF and FCFE can be used to compare the investment potential of different companies.

When to Use FCFF and FCFE

FCFF is typically used to value companies, while FCFE is used to value equity. FCFF is also used to evaluate a company's ability to service its debt.

Example:

Let's say that a company has the following financial statements:

To calculate FCFF we first must find the effective tax rate for the company, to do this we can use the income before tax and the Income Tax paid fields as such:

Tax Rate = Income Tax Expense / Income Before Tax

Tax Rate = 3M / 13M = 23.077% = ~23.08%

Next, we can locate OCF to be $8M, Interest Expense to be $7M, and Capex to be $1M (in addition to our tax rate above of 23.08%). Now we have the necessary innputs to calculate FCFF, which can be done like so:

FCFF = OCF + Tax-Adjusted Interest Expense (TAIE) - Capex

FCFF = $8M + (-$7M * (1 - 0.2308)) - $1M

FCFF = $8M - $5.385M - $1M

FCFF = $1.615M

Lastly, we can use these same inputs alongside Net Debt Issuance (from the cashflow statement) to caluclate FCFE:

FCFE = OCF - Capex + Net Debt Issuance

FCFE = $8M - $1M + $1.5M

FCFE = $8.5M

Conclusion

FCFF and FCFE are two important metrics that can be used to value companies and evaluate their financial performance. FCFF is typically used to value companies, while FCFE is used to value equity. FCFF is also used to evaluate a company's ability to service its debt.