FCFE vs FCFF
high confidence — compiled with source citation from the investment brain.
FCFE vs FCFF
FCFE vs FCFF
A dcf-valuation can be built two ways depending on whose cash flows you discount: cash flow to the firm (FCFF), which belongs to all claimholders — debt and equity together — or free cash flow to equity (FCFE), which is what is left for shareholders after everyone else is paid. aswath-damodaran's cash-flow notes lay out the mechanics of both and the discipline of matching each to the right discount rate.
Two starting points
The choice of starting line determines which cash flow you are measuring: "If looking at cash flows to equity, look at earnings after interest expenses - i.e. net income" whereas "If looking at cash flows to the firm, look at operating earnings after taxes." The formulas follow:
EBIT (1 - tax rate) − (Capital Expenditures - Depreciation) − Change in Working Capital = Cash flow to the firm
Net Income − (Capital Expenditures - Depreciation) − Changes in non-cash Working Capital − (Principal Repayments - New Debt Issues) = Free Cash flow to Equity
The structural difference is the financing term. FCFF is pre-debt: it ignores interest and debt repayments, because it belongs to creditors and owners jointly. FCFE is post-debt: it starts from net income (already after interest) and nets out principal repayments against new debt.
Where the interest tax shield lives
The notes pose the question directly: "Where are the tax savings from interest payments in this cash flow?" The answer differs by model. In FCFF, the shield is in the discount rate — the after-tax cost of debt used in the cost-of-capital. In FCFE, the shield is in the cash flow itself — net income already reflects the interest deduction. This is the core reason each cash flow must be paired with its own rate: FCFF is discounted at the weighted-average cost of capital (all claimholders), FCFE at the cost of equity (shareholders only).
Equity value vs firm value
The two models answer slightly different questions. FCFF yields the value of the firm; to get the equity value you subtract the market value of debt. FCFE yields the equity value directly. Damodaran's teaching emphasizes that actual dividends are a poor proxy for either: "In the strictest sense, the only cash flow that an investor will receive from an equity investment in a publicly traded firm is the dividend that will be paid on the stock", but managers smooth and hoard, so "When actual dividends are less than potential dividends, using a model that focuses only on dividends will under state the true value of the equity in a firm."
Leverage is not a free lunch
FCFE invites an obvious error: lever up, and short-term cash flows to equity rise. The notes correct this in a section titled "FCFE and Leverage: Is this a free lunch?" — increasing debt raises expected FCFE and the cost of equity used to discount it, and whether value rises, falls, or is unchanged depends on the company and its starting leverage. The point mirrors the accounting-quality lesson: the cash flow and the risk must be adjusted together or the number is meaningless.
Where it fits
The FCFE/FCFF split is the cash-flow half of the discount-rate pairing at the center of cost-of-capital, and it feeds directly into the terminal-value perpetuity, which can be built on either cash flow as long as the rate matches.
Sources
damodaran/markdown/cashflows.md