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

Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE)

Updated 11 October 2026 · Fact-checked

FCFF is the cash a business generates for all capital providers, after tax and reinvestment, before debt payments. FCFE is the cash left for shareholders after debt interest and net borrowing. Discount FCFF at WACC to get firm value. Discount FCFE at the cost of equity to get equity value.

Understand Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE)

A company's value comes from the cash it can pay to those who fund it. Profit is not cash. Free cash flow adjusts profit for non-cash items and for the money the business must reinvest to keep growing.

FCFF (free cash flow to the firm) is the cash available to all providers of finance: shareholders and lenders. It is measured before any payment to lenders. You discount it at the WACC. The result is the value of the whole firm. To get equity value, you subtract the market value of debt.

FCFE (free cash flow to equity) is the cash available to shareholders only. It is measured after interest, after tax and after loan repayments and new borrowing. You discount it at the cost of equity. The result is the value of equity directly.

The two must match in what they are paired with. FCFF goes with WACC. FCFE goes with the cost of equity. Mixing them is the most common way to lose marks.

Use FCFF when gearing is expected to change or is hard to forecast, because the cash flows do not depend on financing. Use FCFE when the debt policy is stable and you want equity value straight away. In AFM you may also be asked to forecast, apply a growth rate to a terminal value, and comment on the limits of the result.

Key rules to remember

FCFF from operating profit (EBIT): FCFF = EBIT × (1 − t) + depreciation − capital expenditure − increase in working capital; t is the tax rate. Use a decrease in working capital as an inflow. Depreciation here means all non-cash charges added back.
FCFF from net income: FCFF = net income + non-cash charges + interest × (1 − t) − capital expenditure − increase in working capital; Add back after-tax interest because FCFF is before payments to lenders.
FCFE from FCFF: FCFE = FCFF − interest × (1 − t) + net borrowing; Net borrowing = new debt raised − debt repaid.
FCFE from net income: FCFE = net income + non-cash charges − capital expenditure − increase in working capital + net borrowing; Net income is already after interest and tax, so do not deduct interest again.
Firm value: Value of firm = Σ FCFF ÷ (1 + WACC)^t, plus terminal value discounted; Equity value = firm value − market value of debt.
Equity value: Value of equity = Σ FCFE ÷ (1 + ke)^t, plus terminal value discounted; ke is the cost of equity. This gives equity value directly.
Constant-growth terminal value: TV at end of year n = CF(n+1) ÷ (r − g) = CF(n) × (1 + g) ÷ (r − g); Valid only when r > g and growth is expected to continue indefinitely. Use WACC for FCFF and ke for FCFE.

How to solve Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE) questions

Use this method for any FCFF or FCFE question. It keeps the cash flow and the discount rate matched.

1Read the requirement. Decide whether you need firm value, equity value or just the free cash flow figure.
2Pick the measure. Use FCFF with WACC for firm value. Use FCFE with the cost of equity for equity value.
3Start from the data given. Work from EBIT or from net income. Do not mix the two starting points.
4Adjust for non-cash items, capital expenditure and working capital. Check the sign of each movement.
5For FCFE, deduct after-tax interest if you started from FCFF, and add net borrowing.
6Forecast each year. Apply any growth rate. Calculate a terminal value with the correct rate.
7Discount at the matching rate. For firm value, subtract debt to reach equity value.
8Comment on the result: key assumptions, sensitivity to growth and the discount rate, and what a decision maker should do.

Quickest way: Build FCFF first, then step down to FCFE

When to use it: Use this when the question gives EBIT, tax, depreciation, capital expenditure, working capital, interest and borrowing, and you need both measures or are unsure which to use.

Write EBIT × (1 − t). This is after-tax operating profit.
Add depreciation. Subtract capital expenditure. Subtract the increase in working capital. This is FCFF.
Subtract interest × (1 − t). Add net borrowing. This is FCFE.
Check: FCFE should equal FCFF minus after-tax interest plus net borrowing.
Discount FCFF at WACC and FCFE at ke. Write the discount rate beside each line so you do not swap them.

Common mistakes in Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE)

Discounting FCFE at WACC, or FCFF at the cost of equity
Students remember the cash flow but forget which investor group it belongs to.
Fix: FCFF belongs to all capital providers, so use WACC. FCFE belongs to shareholders, so use ke. Write the rate next to the cash flow.
Deducting interest in FCFF
Students start from net income, which is already after interest, and forget it must be added back for FCFF.
Fix: For FCFF, work from EBIT, or add back interest × (1 − t) to net income. Leave financing out of FCFF.
Deducting full interest instead of after-tax interest
Students forget that interest saves tax.
Fix: When moving from FCFF to FCFE, deduct interest × (1 − t), using the tax rate given.
Wrong sign on working capital or net borrowing
Students treat every movement as an outflow.
Fix: An increase in working capital is an outflow. A decrease is an inflow. New borrowing is an inflow. Repayment is an outflow.
Forgetting to subtract debt after valuing the firm with FCFF
Students stop at firm value and quote it as the value of shares.
Fix: Equity value = firm value − market value of debt. Then divide by the number of shares if a share price is needed.
Using a terminal value formula when the growth rate is not below the discount rate
Students apply the formula without checking its condition.
Fix: Check that r > g first. If not, the constant-growth formula does not work and you should comment on the assumption.

Worked examples

Example 1

Delta Ltd expects the following for next year: EBIT $8,000,000; tax rate 25%; depreciation $1,200,000; capital expenditure $2,000,000; increase in working capital $500,000; interest $1,000,000; new borrowing net of repayments $600,000. Calculate FCFF and FCFE.

Show the solution

EBIT × (1 − t) = 8,000,000 × 0.75 = $6,000,000.
Add depreciation: 6,000,000 + 1,200,000 = 7,200,000.
Subtract capital expenditure: 7,200,000 − 2,000,000 = 5,200,000.
Subtract increase in working capital: 5,200,000 − 500,000 = 4,700,000. This is FCFF.
After-tax interest = 1,000,000 × 0.75 = 750,000.
FCFE = 4,700,000 − 750,000 + 600,000 = 4,550,000.

Answer: FCFF = $4,700,000. FCFE = $4,550,000.

Example 2

Using Delta Ltd's FCFF of $4,700,000 and FCFE of $4,550,000 for next year, both expected to grow at 4% a year indefinitely, calculate the value of the firm and the value of equity. WACC is 9%, cost of equity is 11% and the market value of debt is $12,000,000.

Show the solution

Firm value = FCFF ÷ (WACC − g) = 4,700,000 ÷ (0.09 − 0.04).
4,700,000 ÷ 0.05 = $94,000,000.
Equity value from FCFF = 94,000,000 − 12,000,000 = $82,000,000.
Equity value from FCFE = 4,550,000 ÷ (0.11 − 0.04).
4,550,000 ÷ 0.07 = $65,000,000.
The two equity values differ because the inputs are not consistent: the 9% WACC and 11% ke imply a different debt level or cost of debt from the stated $12,000,000 and the assumed constant net borrowing. Comment on this and say which figure you rely on.

Answer: Firm value = $94,000,000. Equity value via FCFF = $82,000,000. Equity value via FCFE = $65,000,000. The gap shows the assumptions are not internally consistent, so you should test the inputs before relying on either figure.

Exam tips

State at the start which measure you are using and why. This earns marks for judgement.
Show every line of the free cash flow build-up. Marks are given for each correct adjustment, even if the final figure is wrong.
Always match the rate to the cash flow: FCFF with WACC, FCFE with ke. Write this beside your discounting.
Do not stop at the number. Comment on growth assumptions, the reliability of forecasts and sensitivity. These earn the professional skills marks for analysis and commercial acumen.
If the answers from FCFF and FCFE differ, say so and explain possible causes, such as changing gearing or inconsistent inputs.

Practice questions from Valuation and the use of free cash flows

Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE) in other exams

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

Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE): frequently asked questions

What is the difference between FCFF and FCFE?

FCFF is the cash available to all providers of finance before debt payments. FCFE is the cash available to shareholders after interest, tax and net borrowing. FCFF values the whole firm. FCFE values equity directly.

How do I calculate FCFE in AFM?

Start with FCFF, subtract interest × (1 − t), and add net borrowing. Or start with net income, add non-cash charges, subtract capital expenditure and the increase in working capital, then add net borrowing.

Which discount rate do I use for FCFF and FCFE?

Use WACC for FCFF and the cost of equity for FCFE. The rate must reflect the risk of the investors who receive the cash flow.

When should I prefer FCFF to FCFE?

Prefer FCFF when gearing is changing or is hard to forecast, because FCFF does not depend on financing. FCFE is easier when the debt policy is stable and you want equity value directly.