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

Free Cash Flow Valuation Models (FCFF and FCFE)

Updated 7 October 2026 · Fact-checked

Free cash flow valuation discounts forecast cash flows to their present value. Discount FCFF at WACC to get firm value, then subtract debt (net of cash) to get equity value. Discount FCFE at the cost of equity to get equity value directly. Add a terminal value for multistage forecasts.

Understand Free Cash Flow Valuation Models

A company is worth the cash it can generate for its investors. Free cash flow models value that cash directly, instead of waiting for dividends. This helps when a firm pays no dividend, or pays one that does not match its capacity to pay.

FCFF (free cash flow to the firm) is cash available to all capital providers, both debt and equity holders, after operating costs, taxes and investment in capital and working capital. Because it belongs to all investors, you discount it at WACC. The result is firm value. To reach equity value, subtract the market value of debt and add back cash and investments if the question treats them as non-operating.

FCFE (free cash flow to equity) is cash available to common shareholders after operating costs, taxes, interest, reinvestment, and net borrowing (new debt less repayments). It is FCFF less after-tax interest plus net borrowing. You discount it at the required return on equity. The result is equity value directly. Divide by shares outstanding for value per share.

Most firms are not at a steady growth rate forever. A single-stage model assumes constant growth, g, from now on. A multistage model forecasts explicit cash flows for several years, then adds a terminal value at the end of the forecast. The terminal value usually uses the Gordon growth formula on the first cash flow after the forecast. Often it is the largest part of the total value.

When to use FCFE rather than a dividend discount model: FCFE suits a firm whose dividends differ from its capacity to pay, or where the investor has a control perspective. Dividends suit a minority investor in a stable payer. FCFF suits a firm whose capital structure is changing or whose FCFE is negative.

Key formulas to remember

FCFF from net income: FCFF = NI + NCC + Int(1 − t) − FCInv − WCInv; NCC is non-cash charges such as depreciation. FCInv is fixed capital investment. WCInv is the increase in working capital.
FCFF from CFO: FCFF = CFO + Int(1 − t) − FCInv (when interest paid is deducted in CFO); Check where interest paid is classified. If interest is in CFO, add back Int(1 − t). Under IFRS, interest paid may instead sit in financing cash flow. Then CFO is already before interest, so do not add back interest. Adjust only for the tax effect: taxes paid in CFO are lower because of the interest deduction, so subtract Int × t. FCFF = CFO − Int × t − FCInv.
FCFF from EBIT: FCFF = EBIT(1 − t) + Dep − FCInv − WCInv; Use the tax rate on EBIT.
FCFF from EBITDA: FCFF = EBITDA(1 − t) + Dep × t − FCInv − WCInv; Depreciation gives a tax shield.
FCFE from FCFF: FCFE = FCFF − Int(1 − t) + Net borrowing; Net borrowing = new debt issued − debt repaid.
FCFE from net income: FCFE = NI + NCC − FCInv − WCInv + Net borrowing; Interest is already deducted in net income.
FCFE from CFO: FCFE = CFO − FCInv + Net borrowing; Quick route when CFO is given.
Firm value, single stage: Firm value = FCFF₁ ÷ (WACC − g); FCFF₁ = FCFF₀ × (1 + g). Requires WACC > g.
Equity value from firm value: Equity value = Firm value − Market value of debt (+ non-operating cash); Preferred stock is also deducted if present.
Equity value, single stage: Equity value = FCFE₁ ÷ (r − g); r is the cost of equity. FCFE₁ = FCFE₀ × (1 + g).
Terminal value: TVₙ = FCFₙ₊₁ ÷ (discount rate − g_long-run); Value is at time n. Discount it back n periods. Use WACC for FCFF and cost of equity for FCFE.
WACC: WACC = wd × rd × (1 − t) + we × re; Use market-value weights.

How to solve Free Cash Flow Valuation Models questions

Use this order for any FCFF or FCFE question. It stops you from mixing discount rates and cash flows.

1Decide the target: firm value (FCFF, WACC) or equity value (FCFE, cost of equity).
2Compute the base free cash flow from the data given. Pick the formula that matches the starting line item (net income, CFO, EBIT or EBITDA).
3Check the growth pattern. One constant rate means single stage. A high growth period followed by a lower rate means multistage.
4Forecast the explicit cash flows. Grow each year by that year's rate.
5Compute terminal value at the end of the explicit period using the first cash flow after it, divided by (rate − long-run g).
6Discount every cash flow and the terminal value at the correct rate, WACC for FCFF and cost of equity for FCFE.
7If you valued the firm, subtract debt (and preferred) and add non-operating cash to get equity value. Divide by shares for a per-share value.
8Sanity check: the discount rate must exceed g, and the answer should be in the units the question asks for.

Quickest way: Match rate to cash flow, then check the bridge

When to use it: Use for single-stage questions or short two-stage questions with an easy terminal value.

Write the pairing first: FCFF with WACC, FCFE with cost of equity.
If FCFE is asked and FCFF is given, convert once: subtract after-tax interest, add net borrowing.
Do the terminal value on the calculator in one line: FCF × (1 + g) ÷ (r − g).
For uneven explicit flows, use CF and NPV on the BA II Plus, and add the terminal value to the final year's cash flow. Use N, I/Y, FV, CPT PV (with PMT = 0) only to discount a single amount, such as the terminal value on its own.
For equity from firm value, subtract debt last. Then eliminate options that skipped this step.

Common mistakes in Free Cash Flow Valuation Models

Discounting FCFF at the cost of equity, or FCFE at WACC.
Both rates are listed in the question and look interchangeable.
Fix: FCFF belongs to all capital providers, so use WACC. FCFE belongs to shareholders, so use cost of equity.
Forgetting to subtract debt after valuing the firm with FCFF.
The calculation ends in a clean number and feels finished.
Fix: Firm value is not equity value. Always subtract market value of debt and preferred stock before dividing by shares.
Using FCFF₀ instead of FCFF₁ in the Gordon formula.
The question gives the current cash flow and students plug it in directly.
Fix: Multiply by (1 + g) first. The formula needs next period's cash flow.
Adding net borrowing with the wrong sign, or using gross interest instead of after-tax interest.
Rushing the FCFF to FCFE bridge.
Fix: FCFE = FCFF − Int(1 − t) + net borrowing. Net borrowing is positive when new debt exceeds repayments.
Not discounting the terminal value back to today.
Students treat terminal value as a present value because it comes from a perpetuity formula.
Fix: The formula gives value at the end of the forecast. Discount it for the same number of periods as the last explicit cash flow.
Subtracting working capital changes when working capital falls.
Treating WCInv as always an outflow.
Fix: An increase reduces free cash flow. A decrease adds to it. Follow the sign of the change.

Worked examples

Example 1

A firm has FCFF₀ of $200 million, expected to grow at 4% forever. WACC is 9%. Market value of debt is $1,160 million and there is no preferred stock or non-operating cash. There are 50 million shares. What is the equity value per share? Options: A) $56.80 B) $60.00 C) $83.20

Show the solution

FCFF₁ = 200 × 1.04 = $208 million.
Firm value = 208 ÷ (0.09 − 0.04) = 208 ÷ 0.05 = $4,160 million.
Equity value = 4,160 − 1,160 = $3,000 million.
Per share = 3,000 ÷ 50 = $60.00.
Check the options: using FCFF₀ instead of FCFF₁ gives 200 ÷ 0.05 = 4,000, less 1,160 = 2,840, and 2,840 ÷ 50 = $56.80 (option A). Skipping the debt deduction gives 4,160 ÷ 50 = $83.20 (option C), the firm value per share trap. Only B uses the full method.

Answer: B) $60.00 per share

Example 2

A company's FCFF in the coming year is $120 million. Interest expense is $30 million, the tax rate is 30%, and net borrowing is $15 million. FCFE is expected to grow at 3% forever. Cost of equity is 8%. What is the equity value? Options: A) $1,980 million B) $2,100 million C) $2,280 million

Show the solution

After-tax interest = 30 × (1 − 0.30) = $21 million.
FCFE₁ = 120 − 21 + 15 = $114 million.
Equity value = 114 ÷ (0.08 − 0.03) = 114 ÷ 0.05 = $2,280 million.
Check the traps: ignoring net borrowing gives 120 − 21 = 99, and 99 ÷ 0.05 = $1,980 million (option A). Using gross interest gives 120 − 30 + 15 = 105, and 105 ÷ 0.05 = $2,100 million (option B). Only the full bridge gives $2,280 million.

Answer: C) $2,280 million

Exam tips

Read the last line of the question first. It tells you whether the target is firm value, equity value or value per share.
Scan the three options. If one option equals the firm value, it is a trap for candidates who forget to subtract debt.
In multistage questions, mark the year the growth rate changes. The terminal value sits at that year and uses the lower growth rate.
Check whether the question gives cash flow at time 0 or time 1. This decides whether you multiply by (1 + g).
If a question mentions a changing capital structure or negative FCFE, FCFF is the more suitable model. If dividends match capacity to pay and the stake is a minority one, the dividend model is acceptable.

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

Free Cash Flow Valuation Models 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 Valuation Models: frequently asked questions

How do I get equity value from FCFF?

Discount FCFF at WACC to get firm value. Then subtract the market value of debt and preferred stock, and add non-operating cash and investments if the question treats them separately. Divide by shares outstanding for value per share.

When should I use FCFE instead of the dividend discount model?

Use FCFE when dividends do not reflect the firm's capacity to pay, or when you take a control perspective. A dividend model fits better for a minority investor in a firm with stable, predictable payouts. Both give the same equity value only if FCFE is fully paid out.

How is terminal value calculated in a free cash flow model?

Take the first free cash flow after the explicit forecast and divide by (discount rate − long-run growth rate). This gives the value at the end of the forecast. Discount it back to today along with the explicit cash flows.

Which discount rate goes with FCFF and FCFE?

FCFF is discounted at WACC because it is available to both debt and equity holders. FCFE is discounted at the cost of equity because it belongs to shareholders only. Mixing them is a very common error.