Advanced Financial Management · Business Valuation

Discounted Cash Flow Valuation (FCFF and FCFE) for CA Final AFM

Q: What is the difference between FCFF and FCFE?

FCFF is the cash available to all capital providers before debt servicing, so it is discounted at WACC to give enterprise value. FCFE is the cash left for shareholders after interest and net borrowing, so it is discounted at the cost of equity to give equity value.

Q: How do I calculate terminal value in DCF for CA Final?

Use the growth-perpetuity formula: TV = final-year cash flow × (1 + g) ÷ (r − g). Use WACC as r for FCFF and Ke for FCFE. Then discount the TV by the factor of the last forecast year.

Q: Which rate do I use for discounting, WACC or cost of equity?

Use WACC when you discount FCFF. Use cost of equity when you discount FCFE. The rate must match the risk of the cash flow and the claimants who receive it.

Q: Do I subtract debt after finding value using FCFE?

No. FCFE is already after interest and net borrowing, so the present value is equity value. You subtract debt only after discounting FCFF to get enterprise value.

Q: What if the growth rate is higher than the discount rate?

The Gordon formula does not work when g is equal to or greater than r, because it gives a zero, negative or infinite value. A stable growth rate must be lower than the discount rate, so check the data and your assumptions.

Updated 5 October 2026 · Fact-checked

DCF valuation finds value as the present value of future free cash flows. Estimate FCFF and discount it at WACC to get enterprise value, or estimate FCFE and discount it at the cost of equity to get equity value. Add a terminal value for years beyond the forecast, then subtract net debt from enterprise value.

Understand Discounted Cash Flow Valuation (FCFF and FCFE)

A business is worth what it can pay out to its investors in the future, adjusted for time and risk. DCF turns this idea into arithmetic. You forecast cash flows, choose a discount rate that matches the risk of those cash flows, and add up the present values.

FCFF (free cash flow to firm) is the cash left after tax-adjusted operating profit is reduced by reinvestment in capex and working capital. It belongs to all capital providers, both lenders and shareholders. So you discount it at WACC, which blends the cost of debt and the cost of equity. The result is enterprise value. Deduct debt (and add surplus cash or non-operating assets) to reach equity value.

FCFE (free cash flow to equity) is what is left for shareholders after interest and net borrowing are accounted for. It belongs only to shareholders, so you discount it at the cost of equity (Ke), usually from CAPM. The result is directly the equity value. Do not deduct debt again.

Forecasts cannot run forever. After an explicit period (often 3 to 5 years) you add a terminal value, which captures all cash flows beyond that point. The usual method is the growth-perpetuity (Gordon) formula, with a stable growth rate g lower than the discount rate. Terminal value is discounted back using the same factor as the last forecast year.

The golden rule: match the cash flow to the rate. FCFF with WACC gives enterprise value. FCFE with Ke gives equity value. Mixing them is the commonest way to lose marks.

Key rules to remember

FCFF: FCFF = EBIT × (1 − t) + Depreciation − Capex − Increase in NWC; Use the tax rate on EBIT, not on PBT. Add back all non-cash charges. If NWC falls, add the decrease.
FCFE from FCFF: FCFE = FCFF − Interest × (1 − t) + Net borrowing; Net borrowing = new debt raised − debt repaid.
FCFE from PAT: FCFE = PAT + Depreciation − Capex − Increase in NWC + Net borrowing; PAT is already after interest, so do not deduct interest again.
Cost of equity (CAPM): Ke = Rf + β × (Rm − Rf); Rm − Rf is the market risk premium. If only Rm is given, subtract Rf first.
WACC: WACC = Ke × E/(D+E) + Kd × (1 − t) × D/(D+E); Use market-value or target weights if given. Use the after-tax cost of debt.
Terminal value (growth perpetuity): TV at year n = FCF(n+1) ÷ (r − g) = FCF(n) × (1 + g) ÷ (r − g); Valid only when g < r. Use r = WACC for FCFF and r = Ke for FCFE.
Enterprise value: EV = Σ FCFF(t) ÷ (1 + WACC)^t + TV(n) ÷ (1 + WACC)^n; Discount TV by the same factor as year n.
Equity value from EV: Equity value = EV − Debt + Cash and non-operating assets; Value per share = Equity value ÷ number of shares.
Equity value from FCFE: Equity value = Σ FCFE(t) ÷ (1 + Ke)^t + TV(n) ÷ (1 + Ke)^n; Debt is already reflected in FCFE, so make no further deduction.

How to solve Discounted Cash Flow Valuation (FCFF and FCFE) questions

Use this sequence for any DCF question. It keeps the cash flow, the rate and the final bridge consistent.

1Read what is asked: enterprise value, equity value or value per share. This decides FCFF or FCFE.
2Compute the free cash flow for each forecast year in a small table: EBIT or PAT, tax, depreciation, capex, change in NWC, and borrowing if FCFE.
3Find the discount rate. Use WACC for FCFF (compute Ke by CAPM and the after-tax Kd with weights). Use Ke for FCFE.
4Compute the terminal value at the end of the explicit period using FCF(n) × (1 + g) ÷ (r − g), or an exit multiple if the question gives one.
5Discount each year's cash flow and the terminal value with the correct factors. Add them.
6For FCFF, convert enterprise value to equity value: subtract debt, add surplus cash. For FCFE, the sum is already equity value.
7Divide by the number of shares if asked, then state the answer with units and a one-line interpretation.

Quickest way: Table-first DCF with a single bridge

When to use it: Use it when the question gives multi-year data and a PV table, and time is short.

Write one row per year with FCF, discount factor and PV. Do not compute factors from scratch if a table is given.
Compute the terminal value on a separate line, then multiply by the last year's factor.
Add the PV column and the PV of TV in one sum.
Do the bridge last: EV − debt + cash, or divide by shares.
Check sense: TV usually forms a large part of value. If it is tiny or negative, recheck g, r and signs.

Common mistakes in Discounted Cash Flow Valuation (FCFF and FCFE)

Discounting FCFE at WACC, or FCFF at Ke.
Students remember the formulas separately and not the pairing of cash flow and rate.
Fix: Write the pair at the top: FCFF with WACC gives EV; FCFE with Ke gives equity value.
Deducting debt from a value obtained using FCFE.
The habit of EV minus debt is applied to every DCF answer.
Fix: FCFE is already after debt servicing. The sum of PVs is equity value. Deduct debt only when you started from FCFF.
Taxing the wrong base or subtracting interest in FCFF.
Students start from PAT or PBT while using the FCFF formula.
Fix: Start FCFF from EBIT × (1 − t). If you start from PAT, add back interest × (1 − t).
Using the pre-tax cost of debt in WACC.
The tax shield is forgotten when the interest rate is given as a plain percentage.
Fix: Always convert to Kd × (1 − t) before weighting.
Discounting terminal value by the wrong year or forgetting to discount it.
TV looks like a final answer, so it is added undiscounted or discounted by n + 1.
Fix: TV at year n is discounted with the year n factor. Use FCF(n+1) in the numerator, which is FCF(n) × (1 + g).
Treating the increase in working capital as an inflow.
Sign confusion between a balance-sheet increase and a cash effect.
Fix: An increase in NWC is a cash outflow, so subtract it. A decrease is an inflow.

Worked examples

Example 1

Case: Vikram Components Ltd expects FCFF of ₹100 lakh, ₹120 lakh and ₹140 lakh in years 1 to 3. After year 3, FCFF will grow at 5% a year forever. WACC is 10%. The company has debt of ₹600 lakh and surplus cash of ₹50 lakh, and has 10 lakh shares. Discount factors at 10%: year 1 = 0.9091, year 2 = 0.8264, year 3 = 0.7513. Find enterprise value, equity value and value per share.

Show the solution

PV of FCFF: 100 × 0.9091 = 90.91; 120 × 0.8264 = 99.17; 140 × 0.7513 = 105.18. Total = ₹295.26 lakh.
Terminal value at year 3 = 140 × 1.05 ÷ (0.10 − 0.05) = 147 ÷ 0.05 = ₹2,940 lakh.
PV of terminal value = 2,940 × 0.7513 = ₹2,208.82 lakh.
Enterprise value = 295.26 + 2,208.82 = ₹2,504.08 lakh.
Equity value = 2,504.08 − 600 + 50 = ₹1,954.08 lakh.
Value per share = 1,954.08 ÷ 10 lakh shares = ₹195.41.

Answer: Enterprise value ₹2,504.08 lakh; equity value ₹1,954.08 lakh; value per share about ₹195.41. About 88% of enterprise value comes from terminal value, so the result is sensitive to g and WACC.

Example 2

Case: For next year, Sagar Foods Ltd expects EBIT of ₹400 lakh, depreciation of ₹60 lakh, capex of ₹100 lakh and an increase in net working capital of ₹20 lakh. Interest will be ₹80 lakh, and the company will raise net new borrowing of ₹30 lakh. Tax rate is 25%. Risk-free rate is 7%, market return is 12% and beta is 1.2. FCFE is expected to grow at 5% a year forever from the next year's level. Compute FCFF, FCFE, cost of equity and the equity value.

Show the solution

FCFF = 400 × (1 − 0.25) + 60 − 100 − 20 = 300 + 60 − 100 − 20 = ₹240 lakh.
After-tax interest = 80 × 0.75 = ₹60 lakh.
FCFE = 240 − 60 + 30 = ₹210 lakh.
Ke = 7% + 1.2 × (12% − 7%) = 7% + 6% = 13%.
Equity value = FCFE(1) ÷ (Ke − g) = 210 ÷ (0.13 − 0.05) = 210 ÷ 0.08 = ₹2,625 lakh.
No debt is deducted because FCFE already reflects interest and borrowing.

Answer: FCFF ₹240 lakh; FCFE ₹210 lakh; Ke 13%; equity value ₹2,625 lakh.

Exam tips

Case-scenario MCQs often test one link only: which rate pairs with which cash flow, or whether debt is deducted. Revise these pairings before the exam.
In written answers, show a clear table of FCFF or FCFE before discounting. Marks are given for each component even if a later step goes wrong.
State your assumption if the question is silent, such as using the given growth rate in perpetuity or treating cash as surplus. Write it in one line.
Keep the PV factors to four decimals as given. Round only the final answer, and keep units (₹ lakh, ₹ crore) consistent through the working.
Add a one-line interpretation: share of value from terminal value, or comparison of value per share with market price.

Practice questions from Business Valuation

Discounted Cash Flow Valuation (FCFF and FCFE) 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 (FCFF and FCFE): frequently asked questions

What is the difference between FCFF and FCFE?

FCFF is the cash available to all capital providers before debt servicing, so it is discounted at WACC to give enterprise value. FCFE is the cash left for shareholders after interest and net borrowing, so it is discounted at the cost of equity to give equity value.

How do I calculate terminal value in DCF for CA Final?

Use the growth-perpetuity formula: TV = final-year cash flow × (1 + g) ÷ (r − g). Use WACC as r for FCFF and Ke for FCFE. Then discount the TV by the factor of the last forecast year.

Which rate do I use for discounting, WACC or cost of equity?

Use WACC when you discount FCFF. Use cost of equity when you discount FCFE. The rate must match the risk of the cash flow and the claimants who receive it.

Do I subtract debt after finding value using FCFE?

No. FCFE is already after interest and net borrowing, so the present value is equity value. You subtract debt only after discounting FCFF to get enterprise value.

What if the growth rate is higher than the discount rate?

The Gordon formula does not work when g is equal to or greater than r, because it gives a zero, negative or infinite value. A stable growth rate must be lower than the discount rate, so check the data and your assumptions.