MSG Team's other articles

11883 What is Perpetuity? – Make Smarter Investment Decisions

Perpetuity is a very important concept in corporate finance. The concept of perpetuity makes it possible to value stocks, real estate and many other investment opportunities. The valuation of perpetuities is theoretically very simple. The concept of perpetuity as well as the formula required for its calculation has been explained in this article: Stream of […]

9014 The Dot Com Bubble of 2001

The new age high tech generation may seem to be immune to market inefficiencies of the past. They may seem to be aware of the true value of everything because of the vast network of information that they are connected to. However, this did not stop them from falling prey to the folly of an […]

10038 IPO: An Exit Route for Start-Ups

The typical successful start-up obtains funding from various private investors at the earlier stages of the business. Now, these investors do not want to stay with the company forever. They just provide capital to help the company become a full-fledged business. Once the operations of the company are in order, the private investors generally want […]

11186 Sale of Assets during Bankruptcy

When a company is facing bankruptcy, it tries to free up as much capital as possible. This freed up capital is used to finance the operations of the firm. One way to free up the capital is to sell fixed assets of the firm. During the bankruptcy process, it is possible for a company to […]

10105 Key Terms and Conditions in a Term Sheet of Startup Funding

In the previous article, we have already learned that term sheets are the basis on which the entire relationship between the entrepreneur and the investor rests. Since there are several different aspects to running a business, there are several key terms and conditions which need to be worked out between the two parties. A collaborative […]

Search with tags

  • No tags available.

We studied the different methods to calculate the free cash flow to the firm (FCFF) in the previous articles. In this article, we will learn about how to derive free cash flow to equity (FCFE). Here too there are multiple methods involved.

However, since we already have a background in calculating cash flows, we need not go into that much detail here.

The calculation of free cash flow to equity is closely linked to the free cash flow to the firm calculation. There are slight differences which need to be highlighted in this article. To understand these differences we need to understand the concept of net borrowing.

Firms could be borrowing money and paying off debt at the same time. This could be because they are refinancing the debt at a cheaper interest rate.

Alternatively, a firm could simply be rolling over its debt to maintain a target debt amount.

Hence there are inflows and outflows that occur as a result of this simultaneously. The firm’s cash position will therefore experience simultaneous inflows and outflows.

We need to consider only the net effect of these flows. This can be calculated in the following manner.

Net Borrowing = Long and short term debt issues – Long and short term debt repayments

This formula is of utmost important while calculating free cash flow to equity (FCFE) and will be used in each of the three cases possible.

Let’s have a look at the details:

Case #1: Deriving Free Cash Flow to Equity (FCFE) From Cash Flow to Operations (CFO)

We understood that the difference between free cash flow to the firm and the cash flow from operations was simply the investment in fixed assets. We do not consider investment in fixed assets to be a part of the cash flow from operations. However, we do consider it while calculating free cash flow to the firm. Hence we arrived at the formula:

FCFF = CFO – FC Investments

In case of free cash flow to equity (FCFE) we need to add one additional step. We need to account for borrowings as well. Now, we are only concerned with the cash that will be available for equity shareholders. Hence if we borrow more, more cash becomes available. If we pay off some debt, we are left with less cash. Notice we are talking about repayment of debt principal. The interest payments have already been accounted for.

Therefore, we need to consider the net effect of the borrowing as well to arrive at free cash flow to equity. The formula for the same is:

FCFE = CFO – FC Inv + Net Borrowing

Case #2: Deriving Free Cash Flow to Equity (FCFE) From Net Income

Once again, lets understand the free cash flow to equity (FCFE) formula in contrast to the free cash flow to firm (FCFF) formula. The formula for deriving free cash flow to firm (FCFF) from net income was:

FCFF = Net Income + Non cash Expenses + After Tax Interest – FC inv – WC Inv

Now, with regards to the after tax interest expenses, we do not need to add them back. As far as the cash flow to equity shareholders is concerned, interest expenses are included in the outflow and hence do not need to be added back.

Also, once again we need to add back the net borrowing figure since it affects that cash that is available to the equity shareholders. The modified formula therefore is

FCFE = Net Income + Non cash Expenses + Net Borrowing – FC inv – WC Inv

Case #3: Deriving Free Cash Flow to Equity (FCFE) From Free Cash Flow to the Firm

Lastly, we have the simplest case of calculating free cash flow to equity (FCFE) if we are given free cash flow to the firm (FCFF) as input. Remember that the difference between free cash flow to equity (FCFE) and free cash flow to firm (FCFF) is only the debt part. Hence, we need to make 2 adjustments.

  • The first adjustment will account for the interest part i.e. it will subtract post tax interest expense from free cash flow to firm (FCFF)

  • The second adjustment will account for the principal part i.e. it will add the net borrowing to the calculation

Thus, to derive free cash flow to equity (FCFE) from free cash flow to firm (FCFF), the formula is:

FCFE = FCFF – Interest Tax Shield + Net Borrowing

It is therefore possible to calculate free cash flow to equity from various types of inputs.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

Calculating Free Cash Flows: The Case of Preferred Shares

MSG Team

Assumptions Used In Equity Valuation

MSG Team