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CFA Level II Exam · Free Cash Flow Valuation

Forecasting Free Cash Flow and Growth Rates for CFA Level 2

Updated 7 October 2026 · Fact-checked

Forecasting free cash flow means projecting FCFF or FCFE for future years. You can build it from sales, margins and investment, or use fundamental growth: sustainable growth g = retention × ROE, and FCFF growth ≈ reinvestment rate × ROIC. Then you adjust for changes in leverage and discount the result.

Understand Forecasting Free Cash Flow and Growth Rates

Free cash flow valuation needs a forecast. A single-stage model needs one growth rate. A multistage model needs explicit cash flows for several years, then a growth rate for the terminal period. The exam tests how you get those numbers from a vignette.

There are two broad ways to forecast. The sales-based approach starts with revenue growth, then applies forecast margins, working capital needs and capital spending to reach FCFF or FCFE line by line. The fundamental growth approach links growth to how much the firm reinvests and how much it earns on that reinvestment.

The sustainable growth rate is g = b × ROE, where b is the share of earnings retained (1 − dividend payout ratio). For FCFE, growth is usually forecast from the FCFE components (net income, net investment, net borrowing). Use an FCFE-based sustainable growth variant only if the vignette defines it. For FCFF, growth is tied to how much after-tax operating profit is put back into the business and the return earned on invested capital. This is why high growth with low reinvestment is a warning sign: the numbers do not fit together.

Capital structure matters most for FCFE. FCFE equals FCFF minus after-tax interest plus net borrowing. If the firm targets a constant debt ratio, net borrowing is a fixed share of net new investment (FCInv − Dep + WCInv), so FCFE grows with the business. If leverage is changing, FCFE growth and FCFF growth differ, and you must forecast debt separately. FCFF is not affected by financing choices, which makes it easier to forecast when leverage will shift.

Key formulas to remember

FCFF from net income
FCFF = NI + NCC + Int(1 − t) − FCInv − WCInv
NCC is non-cash charges, FCInv is fixed capital investment, WCInv is working capital investment.
FCFE from FCFF
FCFE = FCFF − Int(1 − t) + Net borrowing
Net borrowing is new debt minus repayments.
FCFE with constant debt ratio
FCFE = NI − (1 − DR)(FCInv − Dep) − (1 − DR)WCInv
DR is the proportion of net new investment (FCInv − Dep + WCInv) financed with debt. Use when the debt financing ratio is held constant.
Retention rate
b = 1 − dividend payout ratio
Retention is the share of earnings kept in the business. Do not replace dividends with FCFE unless the vignette tells you to.
Fundamental growth (FCFF)
g = reinvestment rate × ROIC, where reinvestment rate = (FCInv − Dep + WCInv) ÷ EBIT(1 − t)
ROIC = EBIT(1 − t) ÷ invested capital.
Sustainable growth
g = b × ROE, with b = 1 − dividend payout ratio
ROE = NI ÷ beginning equity. This is the standard fundamental growth formula for equity.
DuPont ROE
ROE = net profit margin × asset turnover × leverage
DuPont shows what drives growth. Higher leverage lifts ROE and g, with more risk.

How to solve Forecasting Free Cash Flow and Growth Rates questions

Use this order for any question on forecasting free cash flow or growth. It keeps the data in the vignette tied to the model.

  1. 1Identify what is asked: FCFF or FCFE, a growth rate, a forecast cash flow or a value.
  2. 2Find the base data in the exhibits: sales, margins, net income, depreciation, capex, working capital, interest, tax rate, debt.
  3. 3Choose the method the vignette points to: sales-based forecast if margins and growth in sales are given; fundamental growth if ROE, payout, retention or ROIC appear.
  4. 4Check the financing assumption. If the debt ratio is constant, use the debt share of net new investment. If leverage changes, forecast debt and interest explicitly.
  5. 5Compute the cash flow or growth rate. For growth, use the right base: retention × ROE for sustainable growth, reinvestment rate × ROIC for FCFF.
  6. 6Test for consistency: growth should match reinvestment, and the terminal growth rate should not exceed long-run economic growth.
  7. 7If asked for value, apply the correct discount rate: WACC for FCFF, cost of equity for FCFE.

Quickest way: Retention × ROE shortcut

When to use it: Use when the vignette gives a dividend payout or retention figure and ROE, and asks for a growth rate or next-year earnings.

  1. Compute retention: b = 1 − dividend payout ratio (or 1 − dividends ÷ NI).
  2. Multiply retention by ROE to get g.
  3. Next-year earnings (or any item the vignette says grows at g) = current value × (1 + g).
  4. Sanity check g against the cost of equity and long-run growth.

Common mistakes in Forecasting Free Cash Flow and Growth Rates

  • Treating FCFE as dividends when computing retention

    Students see FCFE as cash paid to equity and plug it into the retention formula.

    Fix: Retention is 1 − dividend payout ratio. Use FCFE-based growth only if the vignette defines it.

  • Applying ROE growth to FCFF

    Both are called fundamental growth, so students mix them up.

    Fix: FCFF uses reinvestment rate × ROIC. Sustainable growth for equity uses retention × ROE.

  • Forgetting the after-tax interest adjustment when moving from FCFF to FCFE

    Students subtract pre-tax interest or skip net borrowing.

    Fix: Always write FCFE = FCFF − Int(1 − t) + Net borrowing.

  • Assuming FCFE and FCFF grow at the same rate

    It holds only when leverage is stable.

    Fix: If debt ratios change, forecast each separately. FCFF is cleaner under changing leverage.

  • Using a terminal growth rate above the long-run economy growth rate

    Students extrapolate a high near-term growth rate.

    Fix: Cap terminal growth at a sustainable level and check that reinvestment supports it.

  • Using ending equity instead of beginning equity for ROE

    The exhibit shows both and students pick the wrong one.

    Fix: Read the vignette's definition. Growth models usually use beginning-of-period equity unless told otherwise.

Worked examples

Example 1

A firm reports net income of ₹80 crore and pays dividends of ₹32 crore this year. Beginning equity is ₹400 crore. (1) What is the retention rate? (2) What is the sustainable growth rate? (3) What is next year's net income if growth equals the sustainable rate?

Show the solution
  1. ROE = 80 ÷ 400 = 20%.
  2. Payout ratio = 32 ÷ 80 = 0.40, so retention b = 1 − 0.40 = 0.60.
  3. g = 0.60 × 20% = 12%.
  4. Next-year net income = 80 × 1.12 = ₹89.6 crore.

Answer: (1) 60%; (2) 12%; (3) ₹89.6 crore.

Example 2

A company has EBIT(1 − t) of ₹500 million. Fixed capital investment is ₹260 million, depreciation ₹140 million, working capital investment ₹30 million. ROIC is 15%. (1) What is the FCFF? (2) What is the reinvestment rate? (3) What is the implied FCFF growth rate?

Show the solution
  1. FCFF = EBIT(1 − t) + Dep − FCInv − WCInv = 500 + 140 − 260 − 30 = ₹350 million.
  2. Net reinvestment = 260 − 140 + 30 = ₹150 million.
  3. Reinvestment rate = 150 ÷ 500 = 30%.
  4. g = 30% × 15% = 4.5%.

Answer: (1) ₹350 million; (2) 30%; (3) 4.5%.

Exam tips

  • Read the vignette for the financing assumption first. It decides whether FCFE can be derived simply from FCFF.
  • Look for ROE, payout or ROIC in the exhibits. Their presence signals a fundamental growth question.
  • Match the discount rate to the cash flow: WACC for FCFF, cost of equity for FCFE.
  • Check units and the base year. Many errors come from using the wrong year's equity or cash flow.
  • If an answer implies growth far above what reinvestment supports, re-read the data. The intended answer is usually consistent.

Forecasting Free Cash Flow and Growth Rates in other exams

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

Forecasting Free Cash Flow and Growth Rates: frequently asked questions

What is the sustainable growth rate formula?

It is g = retention rate × ROE, where retention is 1 − dividend payout ratio. It tells you how fast equity can grow if retained earnings earn ROE. For FCFE, growth is usually forecast from its components unless the vignette defines another method.

When should I use FCFF instead of FCFE?

Use FCFF when leverage is high or changing, or when FCFE is negative. FCFF is not affected by financing choices and is discounted at WACC to give firm value.

What is the sales-based approach to forecasting FCFF?

You forecast sales growth, then apply margins, depreciation, capex and working capital assumptions to reach FCFF each year. It lets you reflect changes in the business that a single growth rate cannot.

How do changes in capital structure affect forecasts?

FCFE includes net borrowing, so changes in debt directly change FCFE. If the debt financing ratio is constant, net borrowing is a fixed share of net new investment. If it changes, forecast borrowing and interest separately.