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Advanced Financial Management · Valuation and the use of free cash flows

Discounted Cash Flow Valuation of Companies in AFM

Updated 11 October 2026 · Fact-checked

DCF valuation finds what a business is worth today by discounting its future free cash flows. Discount FCFF at WACC to get firm value, then deduct debt to get equity value. Or discount FCFE at the cost of equity to get equity value directly. Add a terminal value for cash flows beyond the forecast period.

Understand Discounted Cash Flow Valuation of Companies

A business is worth the cash it can pay to its investors in the future, adjusted for the time value of money and risk. DCF valuation puts this idea into numbers. You forecast cash flows, choose a discount rate that reflects their risk, and add up the present values.

There are two routes. Free cash flow to the firm (FCFF) is the cash left after tax and after reinvestment in assets and working capital, but before payments to debt holders and shareholders. It belongs to all capital providers, so you discount it at the WACC. The result is the value of the whole business. You then deduct the market value of debt to reach equity value.

Free cash flow to equity (FCFE) is the cash left for shareholders after interest, tax, reinvestment and net borrowing. It belongs only to shareholders, so you discount it at the cost of equity. The result is equity value directly. Match the cash flow to the rate. Mixing them is the most costly error in this topic.

You cannot forecast cash flows forever, so you forecast explicitly for a few years and then add a terminal value (TV). The usual method treats cash flows after the forecast period as growing at a constant rate g for ever. The TV is then a growing perpetuity, valued at the end of the last forecast year and discounted back like any other cash flow. In many questions the TV is more than half of the total value, so the growth rate and discount rate assumptions matter a lot.

In AFM you are also asked to comment. Is the growth rate realistic? Is WACC stable if the capital structure is changing? Does the value look reasonable against other methods such as P/E or asset values? Marks come from the numbers and from this judgement.

Key rules to remember

FCFF
FCFF = EBIT × (1 − t) + depreciation − capital expenditure − increase in working capital
Use tax on operating profit, not on profit after interest. Add back other non-cash charges too. Interest is not deducted.
FCFE
FCFE = FCFF − interest × (1 − t) + net new borrowing
Equivalent to profit after tax + depreciation − capex − increase in working capital + net new borrowing.
Present value of explicit cash flows
PV = Σ CFt ÷ (1 + r)^t
r is WACC for FCFF and cost of equity for FCFE.
Terminal value (constant growth)
TVn = CFn × (1 + g) ÷ (r − g)
Valid only when r > g. It gives the value at the end of year n. Discount it by (1 + r)^n.
Firm value to equity value
Equity value = PV of FCFF (incl. TV) − market value of debt + surplus cash or non-operating assets
Use the market value of debt where given, not the book value.
Sustainable growth
g = retention rate × return on new investment
Use it to test whether an assumed growth rate is supported by reinvestment.

How to solve Discounted Cash Flow Valuation of Companies questions

Use the same order for every DCF valuation question. It keeps the discount rate matched to the cash flow and stops you losing marks on the terminal value.

  1. 1Decide what you are valuing: the whole firm (FCFF at WACC) or equity (FCFE at cost of equity). Follow the requirement and the data given.
  2. 2Build the free cash flow for each forecast year. Show each line: operating profit, tax, add back depreciation, deduct capex and working capital investment. For FCFE, also adjust for interest and net borrowing.
  3. 3Choose the discount rate. Use the WACC or cost of equity given, or calculate it if asked. Check that the rate suits the cash flow.
  4. 4Calculate the terminal value at the end of the last forecast year with CFn × (1 + g) ÷ (r − g). State the growth assumption.
  5. 5Discount the explicit cash flows and the terminal value to year 0. Add them up.
  6. 6If you used FCFF, deduct debt at market value and add surplus cash to reach equity value. Divide by the number of shares if a value per share is asked.
  7. 7Comment briefly. Cover the share of value in the terminal value, how sensitive the answer is to g and the discount rate, and how reliable the forecasts are.

Quickest way: Table plus single terminal value line

When to use it: Use this when time is short and the forecast has three to five years followed by constant growth.

  1. Write the years across the page and put the cash flows on one row. Put the discount factors on the next row.
  2. Compute the terminal value once and place it in the final year column. Use the same discount factor as that year's cash flow.
  3. Add the cash flow and the terminal value in the final year before discounting, so you multiply only once.
  4. Sum the present values. For FCFF, deduct debt in the last line and stop.
  5. Write one or two comment lines on growth and discount rate sensitivity if marks are available for it.

Common mistakes in Discounted Cash Flow Valuation of Companies

  • Discounting FCFF at the cost of equity, or FCFE at WACC.

    Students pick the rate they have calculated most recently without thinking about who owns the cash flow.

    Fix: Write the pairing at the top of your answer: FCFF with WACC gives firm value, FCFE with cost of equity gives equity value.

  • Forgetting to deduct debt after valuing FCFF.

    The PV total looks like a final answer, so the student stops.

    Fix: Treat the FCFF total as firm value. Always subtract the market value of debt before stating equity value or a share price.

  • Using the wrong year for the terminal value, for example discounting by one year too few or too many.

    The formula uses CFn × (1 + g), which produces a value at year n, but students discount it as if it arose at year n + 1 or at year 0.

    Fix: The TV from CFn × (1 + g) ÷ (r − g) is a year n value. Discount it with the year n factor.

  • Deducting interest in FCFF or ignoring it in FCFE.

    Students mix up the two definitions of free cash flow.

    Fix: FCFF is before financing flows. FCFE is after interest and after net borrowing. Check the definition before you build the cash flow.

  • Using a terminal growth rate that is close to or above the discount rate, or higher than long-term economic growth without justification.

    Students take a recent high growth rate and apply it forever.

    Fix: Keep g below r and at a level the economy and the firm's reinvestment can support. Comment on the choice and test a lower rate.

  • Taking tax on profit after interest, or ignoring the tax timing given in the question.

    Students start from profit before tax by habit.

    Fix: For FCFF, start from EBIT and apply tax to it. Follow any timing or capital allowance instructions in the question.

Worked examples

Example 1

Delta Co forecasts free cash flow to the firm of $40m, $44m and $48m in years 1, 2 and 3. After year 3, FCFF is expected to grow at 3% a year for ever. Delta's WACC is 9%. The market value of its debt is $200m. Estimate the value of the firm and of its equity.

Show the solution
  1. Discount factors at 9%: year 1 = 1 ÷ 1.09, year 2 = 1 ÷ 1.1881, year 3 = 1 ÷ 1.295029.
  2. PV of explicit cash flows: 40 ÷ 1.09 = 36.70. 44 ÷ 1.1881 = 37.03. 48 ÷ 1.295029 = 37.07. Total = 110.80.
  3. Terminal value at end of year 3 = 48 × 1.03 ÷ (0.09 − 0.03) = 49.44 ÷ 0.06 = 824.0.
  4. PV of terminal value = 824.0 ÷ 1.295029 = 636.28.
  5. Firm value = 110.80 + 636.28 = 747.08.
  6. Equity value = 747.08 − 200 = 547.08.
  7. Comment: the terminal value is about 85% of firm value, so the result is very sensitive to the 3% growth rate and the 9% WACC.

Answer: Firm value is about $747.1m and equity value is about $547.1m.

Example 2

Echo Co expects the following in year 1: profit after tax $60m, depreciation $25m, capital expenditure $40m, increase in working capital $5m and new net borrowing $10m. FCFE in year 2 is forecast at $54m. From year 3, FCFE is expected to grow at 4% a year for ever. Echo's cost of equity is 12%. Estimate the value of Echo's equity.

Show the solution
  1. Year 1 FCFE = 60 + 25 − 40 − 5 + 10 = 50.
  2. Year 2 FCFE = 54 (given).
  3. Terminal value at end of year 2 = 54 × 1.04 ÷ (0.12 − 0.04) = 56.16 ÷ 0.08 = 702.
  4. Discount at the cost of equity, because these are cash flows to shareholders only. Year 1 factor = 1 ÷ 1.12. Year 2 factor = 1 ÷ 1.2544.
  5. PV of year 1 = 50 ÷ 1.12 = 44.64. PV of year 2 = 54 ÷ 1.2544 = 43.05.
  6. PV of terminal value = 702 ÷ 1.2544 = 559.63.
  7. Equity value = 44.64 + 43.05 + 559.63 = 647.32.
  8. No debt deduction is needed. FCFE already takes account of interest and net borrowing.

Answer: The equity value is about $647.3m.

Exam tips

  • Read the requirement first. If it asks for equity value, check whether the data gives FCFF with WACC or FCFE with cost of equity, and pick the route that matches.
  • Show the cash flow build-up line by line. Marks are given for each correct element, even when the final value is wrong.
  • Always comment on the terminal value share, the growth assumption and sensitivity. Section A cases and Section B questions reward these points as technical and professional skills marks.
  • If the capital structure is expected to change, say that a constant WACC may not be reliable. Suggest APV or a changing discount rate as an alternative.
  • State your assumptions in a line or two, such as the timing of cash flows and the tax treatment. It shows commercial awareness and protects marks.

Practice questions from Valuation and the use of free cash flows

Discounted Cash Flow Valuation of Companies in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Discounted Cash Flow Valuation of Companies: frequently asked questions

Should I use FCFF or FCFE in the AFM exam?

Follow the data and the requirement. FCFF discounted at WACC gives firm value, and you deduct debt to reach equity value. FCFE discounted at the cost of equity gives equity value directly. FCFF is often easier when gearing is expected to change.

How do I calculate the terminal value in a DCF valuation?

For constant growth, use TV = CFn × (1 + g) ÷ (r − g). This gives a value at the end of year n. Discount it back by the year n factor and add it to the PV of the explicit cash flows.

What growth rate should I use for the terminal value?

Use the rate given in the question. If you must choose, keep it below the discount rate and at a level that the economy and the company's reinvestment can support. Explain your choice and say how the value changes if g is lower.

Do I deduct debt after a FCFE valuation?

No. FCFE is the cash flow left for shareholders after interest and net borrowing, so discounting it gives equity value already. You deduct debt only when you start from FCFF.