NISM-Series-XV: Research Analyst · Valuation Principles

Discounted Cash Flow Valuation: FCFF and FCFE

Q: What is the difference between FCFF and FCFE?

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

Q: How do I calculate terminal value using the Gordon growth model?

Divide the cash flow of the year after the forecast period by the discount rate minus the growth rate. In symbols, TV = CFn × (1 + g) ÷ (r − g). Then discount it back by n years to today.

Q: Why must growth be lower than the discount rate?

If g is equal to or above r, the denominator becomes zero or negative and the formula gives an infinite or negative value. A company also cannot grow faster than the economy forever, so g is kept modest.

Q: Which gives equity value directly, FCFF or FCFE?

FCFE gives equity value directly. FCFF gives firm value, and you must subtract net debt and other claims to reach equity value.

Updated 11 October 2026 · Fact-checked

DCF valuation finds intrinsic value by discounting expected future free cash flows to today. FCFF belongs to all capital providers and is discounted at WACC to get firm value. FCFE belongs to shareholders and is discounted at cost of equity to get equity value. Add a terminal value for years beyond the forecast.

Understand Discounted Cash Flow Valuation (FCFF and FCFE)

A share or a business is worth the cash it will give its owners in future. DCF turns that idea into numbers. You forecast cash flows, then discount each one back to today because ₹1 received later is worth less than ₹1 now.

There are two versions. FCFF (free cash flow to the firm) is the cash left after operating costs, tax and investment, before paying any lender or shareholder. It belongs to both debt and equity holders. So you discount it at the WACC, the blended cost of debt and equity. The result is enterprise (firm) value. To reach equity value, subtract net debt (debt minus cash) and other claims.

FCFE (free cash flow to equity) is the cash left for shareholders after interest and after net borrowing. You discount it at the cost of equity. The result is equity value directly. Divide by number of shares for value per share.

Forecasts cannot run forever. After an explicit period (often 5 to 10 years), you add a terminal value. The common method is the Gordon growth model: assume cash flow grows at a constant rate g forever. g must be below the discount rate, and it should not exceed the long-run growth of the economy. Terminal value is often a large share of total value, so small changes in g or the discount rate move the answer a lot.

The rule that ties it together: match the cash flow to the discount rate. FCFF with WACC. FCFE with cost of equity. Mixing them is the most tested error.

Key formulas to remember

FCFF from net income: FCFF = Net income + Non-cash charges + Interest × (1 − t) − Fixed capital investment − Increase in working capital; t is the tax rate. Interest is added back after tax because FCFF is before payments to lenders.
FCFF from EBIT: FCFF = EBIT × (1 − t) + Depreciation − Capex − Increase in working capital; Use the increase in non-cash working capital. A decrease adds to cash flow.
FCFE from FCFF: FCFE = FCFF − Interest × (1 − t) + Net borrowing; Net borrowing = new debt raised − debt repaid.
FCFE from net income: FCFE = Net income + Depreciation − Capex − Increase in working capital + Net borrowing; Interest is already deducted in net income, so do not subtract it again.
Firm value (FCFF): Firm value = Σ FCFFt ÷ (1 + WACC)^t + Terminal value ÷ (1 + WACC)^n; Equity value = Firm value − Debt + Cash (net debt deducted).
Equity value (FCFE): Equity value = Σ FCFEt ÷ (1 + ke)^t + Terminal value ÷ (1 + ke)^n; ke is the cost of equity.
Terminal value (Gordon growth): TVn = CFn+1 ÷ (r − g) = CFn × (1 + g) ÷ (r − g); Valid only when g < r. r is WACC for FCFF and ke for FCFE.
WACC: WACC = E/V × ke + D/V × kd × (1 − t); Weights use market values of equity and debt.

How to solve Discounted Cash Flow Valuation (FCFF and FCFE) questions

Use this order for any DCF question, whether it asks for a cash flow, a terminal value or a final value per share.

1Identify which cash flow the question uses: FCFF (firm, pre-debt payments) or FCFE (equity, after debt flows).
2Pick the matching discount rate: WACC for FCFF, cost of equity for FCFE.
3Compute each year's cash flow using the correct formula. Check the treatment of interest, tax, depreciation, capex and working capital.
4Compute terminal value at the end of the forecast year n using CFn × (1 + g) ÷ (r − g). Confirm g < r.
5Discount each cash flow and the terminal value to today. The terminal value is discounted by n years, the same as the year n cash flow.
6Add the present values. For FCFF this gives firm value: subtract net debt to reach equity value.
7Divide equity value by shares outstanding if the question wants value per share, then check the answer is sensible.

Quickest way: Match, Gordon, discount, bridge

When to use it: Use when options are numbers and time is short, especially single-period or one-stage questions.

Match cash flow to rate: FCFF with WACC, FCFE with ke.
If the cash flow grows forever at g, value today = next year's cash flow ÷ (r − g).
If the question gives the current year's cash flow, multiply by (1 + g) first.
For FCFF, subtract net debt to get equity value. For FCFE, no bridge is needed.
Eliminate options that use the wrong rate or skip the terminal value discounting.

Common mistakes in Discounted Cash Flow Valuation (FCFF and FCFE)

Discounting FCFF at the cost of equity, or FCFE at WACC.
Students remember the formulas but not why the rate must match the claimant.
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 with FCFF.
The FCFF total looks like a final answer.
Fix: FCFF gives firm value. Subtract net debt (and other claims) to get equity value before dividing by shares.
Using CFn instead of CFn × (1 + g) in the Gordon formula.
The formula is written with CF(n+1) and students skip the growth step.
Fix: The numerator is always next year's cash flow. If given the current one, grow it by g.
Using a terminal growth rate equal to or above the discount rate.
Students pick a high growth rate without checking r − g.
Fix: The model works only when g < r. If g ≥ r the formula gives nonsense, and g should also stay near long-run economic growth.
Discounting the terminal value by n − 1 or n + 1 years.
Confusion between the year of the last cash flow and the year the formula uses.
Fix: Terminal value computed from year n+1 cash flow sits at the end of year n. Discount it by n years.
Subtracting interest again when starting FCFE from net income.
Students remember that FCFE is after interest and deduct it twice.
Fix: Net income is already after interest. Only add net borrowing, not subtract interest.

Worked examples

Example 1

A firm's FCFF is expected to be ₹120 crore next year and to grow at 5% forever. WACC is 11%. Net debt is ₹500 crore and there are 10 crore shares. Find the value per share.

Show the solution

Cash flow is FCFF, so the rate is WACC = 11%.
Firm value = 120 ÷ (0.11 − 0.05) = 120 ÷ 0.06 = ₹2,000 crore.
Equity value = 2,000 − 500 = ₹1,500 crore.
Value per share = 1,500 ÷ 10 = ₹150.

Answer: ₹150 per share

Example 2

A company's FCFE this year is ₹40 crore. It is expected to be ₹44 crore next year, then grow at 6% a year forever from that point. Cost of equity is 14%. Find the equity value today (assume next year's cash flow arrives at the end of year 1).

Show the solution

FCFE is discounted at the cost of equity, 14%.
At the end of year 1, the cash flow is ₹44 crore, and growth starts after that, so the value at the end of year 1 of flows from year 2 on is 44 × 1.06 ÷ (0.14 − 0.06) = 46.64 ÷ 0.08 = ₹583 crore.
Present value of the year 1 cash flow = 44 ÷ 1.14 = ₹38.60 crore.
Present value of the later flows = 583 ÷ 1.14 = ₹511.40 crore.
Equity value = 38.60 + 511.40 = ₹550 crore.

Answer: About ₹550 crore

Exam tips

Read the first line for the cash flow type. Then pick the rate before you calculate anything.
When FCFF is used and the question asks for value per share, expect a net debt deduction. Options often include the unadjusted firm value as a trap.
Check whether the given cash flow is current or next year's before applying Gordon growth.
Remember that terminal value is often a large part of total value, so questions may ask about sensitivity to g and the discount rate.
With negative marking, skip a calculation only if you cannot match the rate and cash flow. Otherwise the elimination steps usually remove two options.

Practice questions from Valuation Principles