CFA Level II Exam · Private Company Valuation

Income Approach for Private Company Valuation: FCFF, FCFE and Capitalized Cash Flow

Updated 7 October 2026 · Fact-checked

The income approach values a private company as the present value of its expected cash flows. Use FCFF discounted at WACC for firm value, or FCFE discounted at cost of equity for equity value. The capitalized cash flow method divides next-period cash flow by (discount rate − growth), like the Gordon growth model.

Understand Income Approach: FCFF, FCFE and Capitalized Cash Flow

The income approach says a business is worth the cash it will produce, discounted for risk. For a private company the idea is the same as for a listed one. The difficulty is the inputs: there is no traded share price, so beta and market data are missing or unreliable.

FCFF is cash available to all capital providers. You discount it at WACC to get firm value, then subtract debt to get equity value. FCFE is cash available to equity holders after debt payments. You discount it at the cost of equity to get equity value directly.

The capitalized cash flow (CCF) method is the single-stage version. It assumes cash flow grows at a constant rate g forever. Firm value = FCFF1 ÷ (WACC − g). Equity value = FCFE1 ÷ (r − g). The denominator (discount rate − g) is the capitalization rate. Use it when the firm is stable and growth is steady. If growth is uneven, use a multistage DCF and a terminal value instead.

For the discount rate you often cannot observe a beta, so the exam gives two routes. The build-up method starts with the risk-free rate and adds an equity risk premium, a size premium and a company-specific premium. The CAPM with adjustments uses a beta (often from guideline public companies, unlevered and relevered to the target's capital structure) and then adds a size premium and a company-specific risk premium. Both end with the same idea: public-market return plus extra for being small and specific risks.

The company-specific premium covers firm-specific risks such as key-person dependence, customer concentration or weak governance. It is a judgment. Separately, a rate built from public-market returns does not normally capture illiquidity, so a discount for lack of marketability (DLOM) may be applied separately when you value a minority private interest. Avoid the DLOM only if the rate or the method already reflects illiquidity, for example when you use private-transaction multiples. Check what the rate and method contain.

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 = new debt issued − debt repaid.
Capitalized cash flow, firm: V(firm) = FCFF1 ÷ (WACC − g), where FCFF1 = FCFF0 × (1 + g); Valid only if WACC > g and growth is constant.
Capitalized cash flow, equity: V(equity) = FCFE1 ÷ (r − g), where FCFE1 = FCFE0 × (1 + g); r is the cost of equity. Capitalization rate = r − g.
Build-up method: r = Rf + ERP + Size premium + Company-specific premium; Implicitly assumes a beta of 1 for the market portion, since no beta term appears.
CAPM with adjustments: r = Rf + β × ERP + Size premium + Company-specific premium; Beta is usually estimated from guideline public companies and adjusted to the target's leverage.
WACC: WACC = E/(D+E) × r + D/(D+E) × Kd × (1 − t); Use target capital structure weights at market values.
Equity from firm value: Equity value = Firm value − Market value of debt; Used after discounting FCFF.

How to solve Income Approach: FCFF, FCFE and Capitalized Cash Flow questions

Use this order for any income approach item set. It keeps you from mixing FCFF and FCFE inputs.

1Read the vignette and note what is asked: firm value or equity value, and whether growth is stable (capitalization) or changing (multistage).
2Pick the matching cash flow and rate: FCFF with WACC, or FCFE with cost of equity. Never cross them.
3Find the cash flow in the exhibit. Check whether it is the current period (CF0) or next period (CF1). Grow CF0 by (1 + g) if needed.
4Build the discount rate. For build-up, add Rf, ERP, size premium and company-specific premium. For CAPM, use β × ERP first, then add the premiums.
5If WACC is needed, weight the cost of equity and after-tax cost of debt using the target capital structure.
6Compute the capitalization rate (r − g) and divide the next-period cash flow by it.
7If you valued the firm, subtract debt to reach equity value. Check the answer is reasonable against the cash flow.

Quickest way: Cap rate shortcut

When to use it: Use when the vignette gives stable growth and asks for a single-stage value or the effect of changing an input.

Write r (or WACC) as a sum of the listed premiums immediately.
Subtract g to get the cap rate.
Divide CF1 by the cap rate; if only CF0 is given, multiply by (1 + g) first.
For what-if questions only the cap rate changes: a higher premium or lower g raises the cap rate and lowers value, so you can compare options without full recalculation.

Common mistakes in Income Approach: FCFF, FCFE and Capitalized Cash Flow

Dividing CF0 by (r − g) instead of CF1
The exhibit gives the latest cash flow and it is the number at hand.
Fix: Check the date label. Multiply by (1 + g) unless the cash flow is already next year's.
Discounting FCFF at the cost of equity or FCFE at WACC
Students remember the formulas but not the pairing.
Fix: FCFF goes with WACC and gives firm value. FCFE goes with cost of equity and gives equity value.
Adding a beta term in the build-up method
It is confused with CAPM.
Fix: Build-up is Rf + ERP + premiums with no beta. Only the CAPM version uses β × ERP.
Forgetting to subtract debt after an FCFF valuation
The firm value looks like a final answer.
Fix: If the question asks for equity value, subtract the market value of debt.
Using the capitalization rate as the discount rate in an explicit forecast
The terms sound alike.
Fix: The cap rate is r − g and applies only to the constant-growth stream. Explicit cash flows are discounted at r.
Double counting illiquidity
Students apply a DLOM automatically, even when the method already reflects illiquidity, such as private-transaction multiples, so the same risk is counted twice.
Fix: A public-market-based rate does not normally capture illiquidity, so a DLOM may be applied separately. Skip it only if the vignette says the rate or the method already reflects illiquidity.

Worked examples

Example 1

Vega Works is a private manufacturer. Its FCFF this year was $10.0 million and is expected to grow 4% a year indefinitely. Target capital structure: 30% debt, 70% equity. Pre-tax cost of debt is 6% and tax rate is 25%. Cost of equity by build-up: risk-free 3%, equity risk premium 5%, size premium 3%, company-specific premium 2%. The market value of debt outstanding is $48 million, which is consistent with the target structure. (1) Cost of equity? (2) WACC? (3) Equity value using capitalized cash flow?

Show the solution

(1) Cost of equity = 3% + 5% + 3% + 2% = 13%.
(2) After-tax cost of debt = 6% × (1 − 0.25) = 4.5%. WACC = 0.70 × 13% + 0.30 × 4.5% = 9.1% + 1.35% = 10.45%.
(3) FCFF1 = 10.0 × 1.04 = 10.4 million. Firm value = 10.4 ÷ (0.1045 − 0.04) = 10.4 ÷ 0.0645 = 161.24 million.
Check: $48 million ÷ $161.24 million is about 29.8%, close to the 30% target debt weight, so the inputs are consistent.
Equity value = 161.24 − 48 = 113.24 million.

Answer: Cost of equity 13%; WACC 10.45%; equity value about $113.2 million.

Example 2

Orrin Foods is private. Expected FCFE next year is €6.0 million, growing at 3% forever. An analyst uses CAPM with adjustments: risk-free 2.5%, beta 1.2 from guideline companies (already relevered), equity risk premium 5%, size premium 2%, company-specific premium 1.5%. (1) Cost of equity? (2) Equity value? (3) If the company-specific premium rises to 3.0%, what is the new equity value?

Show the solution

(1) Cost of equity = 2.5% + 1.2 × 5% + 2% + 1.5% = 2.5% + 6% + 2% + 1.5% = 12.0%.
(2) Cap rate = 12.0% − 3.0% = 9.0%. Value = 6.0 ÷ 0.09 = 66.67 million.
(3) New cost of equity = 13.5%. Cap rate = 10.5%. Value = 6.0 ÷ 0.105 = 57.14 million.

Answer: Cost of equity 12.0%; equity value about €66.7 million; with the higher premium about €57.1 million, a fall of about 14%.

Exam tips

Check whether the cash flow in the exhibit is current or next period before you divide.
Match cash flow, rate and result: FCFF, WACC, firm value; FCFE, cost of equity, equity value.
Questions often ask the direction of change when a premium or growth rate moves. Reason through the cap rate instead of calculating.
Read whether illiquidity is already reflected in the discount rate before accepting a further marketability discount.
Estimate quickly and eliminate options that ignore debt (for FCFF questions) or use the wrong rate.

Income Approach: FCFF, FCFE and Capitalized Cash Flow in other exams

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

Income Approach: FCFF, FCFE and Capitalized Cash Flow: frequently asked questions

What is the capitalized cash flow method?

It values a business as next period's cash flow divided by the capitalization rate, which is the discount rate minus the constant growth rate. It is the Gordon growth idea applied to FCFF or FCFE. It suits stable, mature private companies.

How does the build-up method differ from CAPM?

Build-up adds a risk-free rate, equity risk premium, size premium and company-specific premium with no beta. CAPM multiplies the equity risk premium by a beta and then adds the extra premiums. Build-up is used when a reliable beta is not available.

When should I use FCFF instead of FCFE?

Use FCFF when capital structure is changing or leverage is high, or when you want firm value. FCFE is simpler when leverage is stable. Always pair FCFF with WACC and FCFE with the cost of equity.

What is the capitalization rate?

It is the discount rate minus the long-run growth rate. A rise in the discount rate or a fall in growth raises it and lowers value. It applies only to the constant-growth cash flow stream.