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CFA Level II · CFA Level II Exam

Free Cash Flow Valuation for CFA Level II

Free cash flow valuation estimates value by discounting cash flow available to capital providers. FCFF goes to all investors and is discounted at WACC to give firm value. FCFE goes to equity holders and is discounted at the cost of equity. Solve by finding the cash flows, the growth rate and the discount rate, then applying the model.

What this chapter covers

This chapter teaches you to value a company from the cash it can generate, not from dividends or accounting earnings. You learn two cash flow measures. FCFF (free cash flow to the firm) is cash available to all capital providers after operating costs, taxes and investment. FCFE (free cash flow to equity) is cash available to common shareholders after debt payments and new borrowing.

You then move from definitions to calculation. You build FCFF and FCFE from net income, EBIT, EBITDA or cash flow from operations, and you forecast them using growth rates. After that you apply single-stage models (a constant growth Gordon-style model) and multistage models with a terminal value. The chapter ends with sensitivity analysis and practical issues, such as negative cash flows and unstable capital structure.

This chapter sits in the Equity Valuation block and connects to several others. It uses cost of capital ideas from Corporate Finance and cash flow statement adjustments from Financial Statement Analysis. It also links to the dividend discount model and to residual income and market multiples, which are other ways to value the same company. Level II tests all of these inside item sets, so you must find the right inputs in a vignette and choose the correct model.

Equity Valuation is a large part of the exam, and free cash flow models are a core method within it. The questions are quantitative and the steps are repeatable, so careful practice turns them into reliable points. The same skills also help in Financial Statement Analysis and Corporate Finance items, because you read cash flow statements, adjust for debt and tax, and judge growth assumptions. Item sets often ask for a calculation, a model choice and an interpretation from one vignette, so one solid grasp of this chapter can earn points across several questions.

Free Cash Flow Valuation: topics in the order to study them

  1. 1Free Cash Flow Concepts: FCFF and FCFEEverything else depends on knowing what each cash flow measures, who receives it and which discount rate matches it.
  2. 2Computing FCFF and FCFE from Financial StatementsVignettes give you statements, not ready-made cash flows, so you need to build them from different starting points.
  3. 3Forecasting Free Cash Flow and Growth RatesModels need a growth input, and you must know how to derive it from fundamentals or forecast it directly.
  4. 4Single-Stage Free Cash Flow Valuation ModelsThe constant growth model is the simplest valuation step and is the base for the terminal value.
  5. 5Multistage Free Cash Flow Valuation and Terminal ValueThis combines forecasting with the single-stage model, so study it only after both are comfortable.
  6. 6Sensitivity Analysis and Practical Issues in FCF ValuationIt tests judgment on top of the mechanics, and it makes more sense once you have done full valuations.

How to prepare Free Cash Flow Valuation

Treat this chapter as a calculation routine you can repeat under time pressure, and build it in layers.

  1. Write the FCFF and FCFE definitions from memory, and state which discount rate pairs with each. Repeat until you do it without hesitation.
  2. Learn each conversion route (from net income, EBIT, EBITDA and CFO) and practise with one set of statements, checking that the routes agree where they should.
  3. Practise forecasting with both methods: a growth rate from fundamentals and a direct forecast of cash flow items. Note which inputs the vignette actually gives you.
  4. Solve single-stage problems first, paying attention to timing: the next-period cash flow goes in the numerator, so grow the latest cash flow by one period when needed.
  5. Do multistage problems in a fixed sequence: explicit-period cash flows, terminal value at the end of the explicit period, discount all of it, and then derive equity value from firm value if needed.
  6. Use item sets to practise reading exhibits. Underline the figures you need and ignore the distractors, then check that units and periods match.
  7. Finish with sensitivity questions. Change one input at a time and say in words how the value moves and why.

Common mistakes in Free Cash Flow Valuation

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

    Fix: Link each cash flow to its claimants first. FCFF serves all capital providers, so use WACC. FCFE serves equity holders, so use the cost of equity.

  • Forgetting to subtract debt after valuing the firm with FCFF.

    Fix: Read the question's wording. If it asks for equity value or value per share, subtract debt and divide by shares.

  • Using the wrong period's cash flow in the constant growth formula.

    Fix: The numerator is the cash flow one period ahead. Multiply the latest cash flow by (1 + g) unless the vignette states the next value.

  • Mixing up the tax adjustment on interest.

    Fix: Remember the direction of the bridge: going from net income to FCFF adds back after-tax interest, while going from FCFF to FCFE subtracts it.

  • Including cash or short-term debt in the working capital change.

    Fix: Use operating items only, such as receivables, inventory and payables, unless the vignette explicitly defines it otherwise.

  • Accepting a terminal growth rate that is too high or a terminal value that dominates the answer without comment.

    Fix: Check that the terminal growth rate is plausible and below the discount rate, and compare the terminal value share with the total. Mention these limits when a question asks for judgment.

Last-day revision: Free Cash Flow Valuation

  • FCFF is cash flow to all capital providers; discount it at WACC to get firm value.
  • FCFE is cash flow to equity holders; discount it at the cost of equity to get equity value.
  • Equity value = firm value − market value of debt (and adjust for other claims the vignette states).
  • FCFE = FCFF − interest × (1 − tax rate) + net borrowing.
  • FCFF = NI + non-cash charges + interest × (1 − tax rate) − FCInv − WCInv.
  • FCFF = EBIT × (1 − tax rate) + depreciation − FCInv − WCInv.
  • FCFE = CFO − FCInv + net borrowing.
  • Use changes in operating working capital only, and exclude cash and short-term debt.
  • Constant growth value = next-period cash flow ÷ (discount rate − g), and it requires g below the discount rate.
  • In multistage models, terminal value is found at the end of the explicit period and then discounted back.
  • Check the terminal value share of total value; a very high share signals a fragile result.
  • Sensitivity analysis changes one input at a time; value is typically most sensitive to the discount rate and the terminal growth rate.

Free Cash Flow Valuation 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: frequently asked questions

What is the difference between FCFF and FCFE?

FCFF is the cash flow available to all capital providers, both debt and equity, before any payments to them. FCFE is what remains for common shareholders after debt service and net borrowing. FCFF gives firm value at WACC, and FCFE gives equity value at the cost of equity.

Which formulas should I memorise for Level II?

Learn the routes from net income, EBIT, EBITDA and CFO to FCFF, and the bridge from FCFF to FCFE. Also learn the constant growth model and the multistage structure with a terminal value. Understand why each term is there, so you can rebuild a formula if you forget it.

How do I choose between FCFF and FCFE in a question?

Look at the capital structure and the data in the vignette. FCFF is often better when leverage is changing or FCFE is negative, because it does not depend on borrowing. FCFE is more direct when leverage is stable and the question asks for equity value.

How should I handle a multistage valuation in the exam?

Write a short timeline. Forecast the cash flows in the explicit period, compute the terminal value at its end using a constant growth model, discount everything to today, and then convert to equity value if needed. A timeline helps you avoid period errors.