CFA Level II Exam · Free Cash Flow Valuation

FCFF vs FCFE: Free Cash Flow Concepts for CFA Level II

Updated 7 October 2026 · Fact-checked

FCFF is the cash flow available to all capital providers (debt and equity) after operating costs, taxes and investment. FCFE is the cash flow available only to common shareholders after debt payments. Start from CFO or net income, adjust for interest, fixed capital investment and net borrowing, then match the cash flow to the right discount rate.

Understand Free Cash Flow Concepts: FCFF and FCFE

Free cash flow is cash the business generates after paying for the investment it needs to keep operating and growing. It is not accounting profit. It is cash that could be paid to investors without hurting operations.

FCFF (free cash flow to the firm) is the cash flow available to all providers of capital: debt holders, preferred shareholders and common shareholders. It is before any payments to them. Because it belongs to all capital providers, you discount it at the WACC. The result is firm value. Subtract the market value of debt (and preferred stock) to get equity value.

FCFE (free cash flow to equity) is the cash flow available to common shareholders only. It is after interest and after net borrowing (new debt less repayments). Because it belongs to equity holders, you discount it at the required return on equity. The result is equity value directly.

Choose FCFF when leverage is high or changing, or when FCFE is negative even though the firm is sound. FCFF is not distorted by debt flows, and the WACC can be held steady while the capital structure changes. Choose FCFE when the capital structure is stable, because FCFE already includes the effect of borrowing and gives equity value in one step.

In a vignette, the work is to read the right figure (net income, CFO, EBIT or EBITDA), pick the correct formula for that starting point, and avoid double counting the interest tax shield.

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 (capex less proceeds from asset sales). WCInv is investment in working capital.
FCFF from CFO: FCFF = CFO + Int(1 – t) – FCInv; This form applies when interest paid is already deducted in CFO. US GAAP always puts interest paid in CFO, so you add back after-tax interest. IFRS allows interest paid in either operating or financing activities, so check the classification. If interest paid is in financing, CFO is before the interest outflow, but taxes paid in CFO already include the interest tax shield. You must remove that shield: FCFF = CFO – Int × t – FCInv.
FCFF from EBIT: FCFF = EBIT(1 – t) + Dep – FCInv – WCInv; Use when the vignette gives operating income.
FCFF from EBITDA: FCFF = EBITDA(1 – t) + Dep(t) – FCInv – WCInv; Depreciation enters only through its 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, so do not subtract it again.
FCFE from CFO: FCFE = CFO – FCInv + Net borrowing; Use this form only when CFO is already after interest paid (always the case under US GAAP, and under IFRS when interest is classified in operating activities). CFO already reflects working capital changes. If interest paid is classified in financing (IFRS), first deduct the full interest paid, not the after-tax amount, because the taxes in CFO already include the interest tax shield: FCFE = CFO – Int – FCInv + Net borrowing.
Valuation by discounting: Firm value = Σ FCFF ÷ (1 + WACC)^t; Equity value = Σ FCFE ÷ (1 + r)^t; FCFF uses WACC. FCFE uses the cost of equity r. Equity value from FCFF = firm value – market value of debt (and preferred stock).

How to solve Free Cash Flow Concepts: FCFF and FCFE questions

Use this method for any FCFF or FCFE question in an item set.

1Decide what the question wants: FCFF or FCFE, and whether it asks for a cash flow, a choice of model, or a value.
2Find the starting figure in the exhibit: net income, CFO, EBIT or EBITDA. Note the tax rate.
3Pick the formula that begins with that figure. Do not mix formulas.
4Check the reporting basis. Under US GAAP, interest paid is in CFO. Under IFRS, interest paid can be in operating or financing activities, so find where the exhibit puts it.
5Collect the adjustments: non-cash charges, after-tax interest, capex net of asset sale proceeds, working capital investment, and net borrowing.
6Watch the signs. Investment reduces free cash flow. Net borrowing adds to FCFE. Working capital increases subtract.
7Compute. For a choice of model, use leverage and its stability: changing or high leverage favours FCFF, stable leverage favours FCFE.
8Match the discount rate: WACC for FCFF, cost of equity for FCFE. Convert firm value to equity value only for FCFF.

Quickest way: Anchor on CFO

When to use it: Use when the vignette gives a cash flow statement. It is the fastest route and has the fewest adjustments. First check where interest paid is classified.

For FCFE: take CFO. If interest paid is in financing (possible under IFRS), subtract the full interest paid. Then subtract capex and add net borrowing.
For FCFF: take CFO. If interest was deducted in CFO, add back after-tax interest. If interest is in financing, subtract Int × t to remove the tax shield already in CFO. Then subtract capex.
Do not subtract working capital again, because CFO already includes it.
Sanity check: FCFE = FCFF – Int(1 – t) + net borrowing.

Common mistakes in Free Cash Flow Concepts: FCFF and FCFE

Adding back interest to net income when computing FCFE.
Students remember the FCFF formula, which does add back after-tax interest.
Fix: FCFE starts from net income, which is already after interest. Only FCFF adds back Int(1 – t).
Adding back full interest instead of interest × (1 – t).
Forgetting that interest creates a tax shield.
Fix: Always use after-tax interest in FCFF formulas. The shield is handled in WACC for discounting.
Subtracting working capital investment again when starting from CFO.
The net-income formulas include a WCInv term, and students carry it over.
Fix: CFO already includes working capital changes. Use FCInv and borrowing only.
Discounting FCFF at the cost of equity or FCFE at WACC.
Both are called free cash flow, so the rates get mixed.
Fix: FCFF goes with WACC and gives firm value. FCFE goes with cost of equity and gives equity value.
Treating FCFF as equity value without subtracting debt.
The discounting step feels like the final answer.
Fix: Subtract the market value of debt (and preferred stock) from firm value to reach equity value.
Ignoring the interest classification under IFRS.
Students assume interest paid is always in CFO, as in US GAAP, or always in financing.
Fix: Read the cash flow statement. IFRS allows either classification. If interest paid is in financing activities, CFO is before the interest outflow but its taxes still include the interest shield. For FCFF, subtract Int × t instead of adding back. For FCFE, deduct the full interest paid.

Worked examples

Example 1

Vignette: A manufacturer reports net income of 240 million, depreciation of 80 million, interest expense of 50 million, and a tax rate of 30%. Capital expenditure is 130 million with no asset sales. Working capital investment is 20 million. The firm borrowed 60 million of new debt and repaid 25 million. Q1: What is FCFF? Q2: What is FCFE? Q3: Which rate should discount FCFE?

Show the solution

Q1: Int(1 – t) = 50 × 0.70 = 35.
FCFF = NI + NCC + Int(1 – t) – FCInv – WCInv = 240 + 80 + 35 – 130 – 20 = 205.
Q2: Net borrowing = 60 – 25 = 35.
FCFE = NI + NCC – FCInv – WCInv + net borrowing = 240 + 80 – 130 – 20 + 35 = 205.
Check: FCFF – Int(1 – t) + net borrowing = 205 – 35 + 35 = 205. It matches.
Q3: FCFE belongs to common shareholders, so it is discounted at the required return on equity.

Answer: FCFF = 205 million; FCFE = 205 million; discount FCFE at the cost of equity.

Example 2

Vignette: A retailer (IFRS) reports CFO of 310 million, with interest paid of 40 million classified in financing activities. Capital expenditure is 150 million. Tax rate is 25%. Net borrowing is a repayment of 30 million. WACC is 9%. Q1: What is FCFF? Q2: What is FCFE? Q3: The firm's debt has a market value of 400 million. If FCFF grows at 3% forever from next year's FCFF of 170 million, what is equity value?

Show the solution

Q1: Interest paid is in financing, so CFO is before the interest outflow. But taxes paid in CFO already include the interest tax shield, so remove it: Int × t = 40 × 0.25 = 10.
FCFF = CFO – Int × t – FCInv = 310 – 10 – 150 = 150.
Q2: Start from FCFF. After-tax interest = 40 × 0.75 = 30.
Net borrowing = –30.
FCFE = 150 – 30 – 30 = 90.
Cross-check from CFO: interest is in financing, so deduct the full interest paid. FCFE = CFO – Int – FCInv + net borrowing = 310 – 40 – 150 – 30 = 90. The plain formula CFO – FCInv + net borrowing would give 130, which is wrong here because it skips the interest.
Q3: Firm value = 170 ÷ (0.09 – 0.03) = 170 ÷ 0.06 = 2,833.33.
Equity value = 2,833.33 – 400 = 2,433.33.

Answer: FCFF = 150 million; FCFE = 90 million; equity value ≈ 2,433 million.

Exam tips

Look at where interest paid sits in the cash flow statement before using any CFO formula. It decides whether you add it back for FCFF or deduct it for FCFE.
When a question asks which measure is better, read the leverage story: changing or high leverage points to FCFF, stable leverage points to FCFE.
Cross-check with FCFE = FCFF – Int(1 – t) + net borrowing. It catches most arithmetic errors fast.
FCFF discounted gives firm value, so look for the debt subtraction step. Many wrong options skip it.
No negative marking, so always answer. Eliminate options that use the wrong discount rate first.

Free Cash Flow Concepts: 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.

Free Cash Flow Concepts: FCFF and FCFE: frequently asked questions

What is the difference between FCFF and FCFE?

FCFF is the cash flow available to all capital providers before debt payments. FCFE is what remains for common shareholders after interest and net borrowing. FCFF is discounted at WACC, FCFE at the cost of equity.

How do I get FCFF from net income?

Use FCFF = NI + non-cash charges + Int(1 – t) – fixed capital investment – working capital investment. You add back after-tax interest because FCFF is before payments to debt holders.

How do I get FCFE from CFO?

Use FCFE = CFO – fixed capital investment + net borrowing when CFO is already after interest paid. That is always so under US GAAP, and under IFRS when interest is classified in operating activities. If IFRS interest paid is in financing, deduct the full interest paid as well: FCFE = CFO – Int – FCInv + net borrowing. Taxes in CFO already include the interest shield, so do not use after-tax interest here. CFO already includes working capital changes.

When is FCFF better than FCFE?

FCFF is better when leverage is high or changing, or when FCFE is negative. It is not affected by debt flows, so forecasting is simpler. FCFE suits firms with stable capital structures.