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ACCA Strategic Professional · Advanced Financial Management · Valuation and the use of free cash flows

A company's free cash flow to the firm (FCFF) is being used to value its equity under a discounted cash flow approach. Which step correctly converts the present value of FCFF into the value of equity?

Discounting FCFF gives enterprise value. To reach equity value you deduct the market value of debt and add surplus cash and non-operating investments, because those assets produce no cash flows within FCFF and debt holders have a prior claim.

  1. AAdd the market value of debt and deduct surplus cash
  2. BDeduct the market value of debt and add surplus cash and non-operating investmentsCorrect
  3. CDeduct the market value of debt and surplus cash
  4. DAdd the market value of debt and non-operating investments

Explanation

FCFF discounted at WACC gives the value of operating assets (enterprise value). Equity value is found by deducting debt and adding assets whose cash flows are excluded from FCFF, such as surplus cash and non-operating investments. Adding debt would overstate equity.

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