CFA Level I Exam · Discounted Cash Flow (DCF) and Growth Models

Choosing and Applying Discount Models: DDM, FCFF, FCFE

Updated 7 October 2026 · Fact-checked

Discounted cash flow models value equity as the present value of expected cash flows. Use DDM when dividends are stable and policy is clear, FCFE when leverage is steady, and FCFF when leverage is changing or negative FCFE is likely. Discount dividends and FCFE at the cost of equity, and FCFF at WACC.

Understand Choosing and Applying Discount Models

A discounted cash flow model says a share is worth the present value of the cash it will deliver to its owners. The three models differ in which cash flow they use and which discount rate matches it.

The dividend discount model (DDM) uses dividends. It works best when the company pays dividends, the dividend policy is clear and related to earnings, and you value a minority stake. It fits mature, stable firms. It fits poorly for firms that pay no dividend or pay far more or less than they can afford.

FCFE is cash available to common shareholders after capital spending, working capital needs and net borrowing. FCFF is cash available to all capital providers, both debt and equity, before debt payments. Free cash flow models suit firms that pay no dividends, or where you take a control perspective, since a controlling owner can decide payout.

Choosing between FCFF and FCFE: FCFE is simpler when leverage is stable, because net borrowing is predictable. FCFF is better when leverage is changing a lot, or when FCFE is negative, because it ignores debt flows. FCFF is discounted at WACC to get firm value, then you subtract debt (and preferred) to get equity value. FCFE and dividends are discounted at the required return on equity.

The required return on equity is often estimated with CAPM. Every DCF model is sensitive to this rate and to the growth rate, so small input changes can move value a lot. That is the main limitation of DCF, along with forecast error and terminal value dominance.

Key formulas to remember

CAPM cost of equity: r = Rf + β × (E(Rm) − Rf); (E(Rm) − Rf) is the equity risk premium. Use the rate matching the cash flow currency.
Gordon growth value (DDM): V0 = D1 ÷ (r − g); Needs r > g and constant growth forever. D1 = D0 × (1 + g).
Equity value from FCFE: Equity value = Σ FCFEt ÷ (1 + r)^t; Discount at cost of equity. Constant growth: FCFE1 ÷ (r − g).
Firm value from FCFF: Firm value = Σ FCFFt ÷ (1 + WACC)^t; Constant growth: FCFF1 ÷ (WACC − g).
Equity value from firm value: Equity value = Firm value − Market value of debt (and preferred); Add non-operating cash if it is not already in the cash flows.
WACC: WACC = wd × rd × (1 − t) + wp × rp + we × re; Use target or market-value weights, not book weights.
FCFE from FCFF: FCFE = FCFF − Interest × (1 − t) + Net borrowing; Use when you are given FCFF and debt information.

How to solve Choosing and Applying Discount Models questions

For any question on model choice or application, work through the company facts and match them to the model and discount rate.

1Read the company description: dividend history, payout policy, leverage and whether the stake is minority or controlling.
2If dividends are stable, linked to earnings and the stake is minority, DDM is suitable.
3If there are no dividends or payout is unrelated to earnings, move to a free cash flow model.
4If leverage is stable, FCFE is suitable. If leverage is changing or FCFE is negative, FCFF is better.
5Match the discount rate: cost of equity for dividends and FCFE, WACC for FCFF.
6Compute the cost of equity with CAPM: Rf + β × equity risk premium.
7Value with the formula, then convert firm value to equity value by subtracting debt if you used FCFF.
8Check r > g and that the answer is reasonable.

Quickest way: Match cash flow to discount rate

When to use it: Use for conceptual items where you must pick a model or spot an error in the discount rate.

Ask: who gets this cash flow? Equity holders only means cost of equity. All capital providers means WACC.
Ask: is the company stable and paying dividends? If yes, DDM. If not, free cash flow.
Ask: is leverage changing? If yes, FCFF.
Eliminate options that pair FCFF with cost of equity or FCFE with WACC.

Common mistakes in Choosing and Applying Discount Models

Discounting FCFF at the cost of equity
Students remember that equity valuation uses cost of equity.
Fix: FCFF belongs to all capital providers, so discount at WACC. Then subtract debt.
Forgetting to subtract debt after FCFF valuation
The PV result feels like the final answer.
Fix: The PV of FCFF is firm value. Subtract debt and preferred shares to get equity value.
Using D0 instead of D1 in the Gordon growth model
The question gives the latest dividend, which is D0.
Fix: Compute D1 = D0 × (1 + g) before dividing by (r − g).
Using the equity risk premium as the market return in CAPM
The terms look similar.
Fix: Check the wording. If given the premium, do not subtract Rf again.
Recommending DDM for a firm with erratic or no dividends
DDM is the first model learned.
Fix: Choose a free cash flow model when payout is unrelated to earnings or absent.
Ignoring that terminal value drives most of the result
Students focus on explicit forecast years.
Fix: Remember DCF is highly sensitive to r and g, and a small change in either can shift value sharply.

Worked examples

Example 1

A mature utility has paid stable dividends. Its last dividend D0 was $2.00, expected growth is 4% forever, Rf is 3%, beta is 0.8 and the equity risk premium is 5%. What is the value per share? A) $52.00 B) $66.67 C) $69.33

Show the solution

Cost of equity = 3% + 0.8 × 5% = 7%.
D1 = 2.00 × 1.04 = $2.08.
V0 = 2.08 ÷ (0.07 − 0.04) = 2.08 ÷ 0.03 = $69.33.
Option A ($52.00) is D1 ÷ 0.04 = 2.08 ÷ 0.04, which uses g as the denominator instead of r − g.
Option B ($66.67) is D0 ÷ 0.03 = 2.00 ÷ 0.03, which forgets to grow the dividend to D1.
The value that matches the correct method is C.

Answer: C) $69.33. Use D1, not D0, and discount at r = 7%.

Example 2

A firm expects FCFF of €120 million next year, growing 3% forever. WACC is 9%. Market value of debt is €600 million. There are 50 million shares. What is the value per share? A) €14.00 B) €28.00 C) €40.00

Show the solution

Firm value = 120 ÷ (0.09 − 0.03) = 120 ÷ 0.06 = €2,000 million.
Equity value = 2,000 − 600 = €1,400 million.
Per share = 1,400 ÷ 50 = €28.00.
Option C (€40.00) is firm value per share, 2,000 ÷ 50, which forgets to subtract debt.

Answer: B) €28.00 per share. Value FCFF at WACC, subtract debt, divide by shares.

Exam tips

Questions are three-option MCQs, so eliminate any option that pairs the wrong cash flow with the wrong discount rate.
Read the stem for clues: no dividends, changing leverage, minority or control stake.
For numeric items, compute D1 or FCFF1 first and check r > g.
Check whether the question gives the equity risk premium or the market return before applying CAPM.
For limitations questions, think forecast error, sensitivity to r and g, and terminal value dominance.

Practice questions from Discounted Cash Flow (DCF) and Growth Models

Choosing and Applying Discount Models: frequently asked questions

When should I use DDM instead of a free cash flow model?

Use DDM when the company pays stable dividends tied to earnings and you value a minority stake. Use a free cash flow model when dividends are absent or unrelated to what the firm can afford to pay. Choose FCFE if leverage is steady, or FCFF if leverage is changing.

When is FCFF better than FCFE?

FCFF is better when leverage is changing significantly or FCFE is negative. It is also useful when the capital structure is complex, since it avoids forecasting debt flows.

Which discount rate goes with which model?

Dividends and FCFE are discounted at the required return on equity, often from CAPM. FCFF is discounted at WACC, and you then subtract debt to reach equity value.

What are the main limitations of DCF valuation?

DCF is very sensitive to the discount rate and growth rate. It relies on uncertain forecasts, and terminal value often makes up most of total value.