FCFF vs FCFE

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lxada269

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Assume there is no debt. In this case, a DCF using FCFF is supposed to equal a DCF using FCFE.
Now suppose there is no debt, but a lot of excess cash. If we use a FCFF approach then we have a much higher value than FCFE because we add back the cash.
2 Questions (1 regarding exam, 1 regarding practice)
1. For the exam, should we add back cash when using a FCFF DCF and there is no debt?
2. In practice, should we add back cash when using a FCFF DCF and there is no debt?
 
add back the cash??? to what? what are you referring to?
you start either with NI or CFO … and adjust for non-cash items, working capital investments and fixed investments…
since there is no net borrowings or interest expense adjustments….your FCFF and FCFE should be equal …
 
the cash balance on the balance sheet is a sort of comperhensive cash balance, which is including CFO, CFF and CFI.
 
… and all this while I though that FCFF will equal to FCFE when there is no outstanding debt (and hence no Interest expense) and the net borrowing was equal to 0.
 
Folks, to quote myself: “a DCF using FCFF is supposed to equal a DCF using FCFE”
The key word: DCF
In a FCFF DCF you subtract debt and add back excess cash to get the value of equity. In a FCFE DCF you do neither because a debt charge is already included in your cash flow in the form of interest.
But if there is no debt, than a DCF with FCFF should equal a DCF with FCFE, theoretically. But a DCF with FCFF would add back excess cash, assuming there is some. A DCF with FCFE would not. What gives?
 
lxada269, i think you are confusing us.
1) if there is not debt discount rates are the same WACC = Cost of Equity
2) FCFE = FCFF - Interest*(1-tax) + change in NetBorrowing
since there is no debt, Interest = 0, change in NetBorrowing = 0 -> FCFF = FCFE
//another way to look at that equity holders are the only ones recieving cash flows from the firm (FCFE = FCFF)
3) DCF (FCFE) = DCF(FCFF) - MV(debt) -> DCF(FCFE) = DCF(FCFF) since debt = 0
I have no idea what you mean when you talk about adding back cash. i think you are confusing something.
 
I think you would add back cash to FCFE as well lxada, that’s where I think you are misunderstanding the concept. Maratkus, when he’s talking about adding back cash, he’s talking about for control valuations. In the CFAI texts it says for change in WC to use change in noncash current assets minus change in non interest paying short term debt such as notes payable. Then after the entire DCF value has been reached, value of cash is added back in as this is cash a buyer could immediately use to pay down the purchase price. However, this step is performed for both FCFE and FCFF valuations, thus arriving at the same theoretical value in a situation with no firm debt. I think that’s where he’s confused.
 
i see Black Swan.
In the formula FCFF = NetIncome + NonCash Charges + I*(1-t)- changes in fixed assets - changes in net working capital
changes in net working capital exclude cash and debt. is that what you mean?
 
Black Swan Wrote:
——————————————————-
> I think you would add back cash to FCFE as well
> lxada, that’s where I think you are
> misunderstanding the concept. Maratkus, when he’s
> talking about adding back cash, he’s talking about
> for control valuations. In the CFAI texts it says
> for change in WC to use change in noncash current
> assets minus change in non interest paying short
> term debt such as notes payable. Then after the
> entire DCF value has been reached, value of cash
> is added back in as this is cash a buyer could
> immediately use to pay down the purchase price.
> However, this step is performed for both FCFE and
> FCFF valuations, thus arriving at the same
> theoretical value in a situation with no firm
> debt. I think that’s where he’s confused.
That is exactly what I meant Black Swan. My only gripe is that in the CFAI texts, I found that adding back cash was only done in a DCF with FCFF. I am assuming this is because the cash can be used to pay off debt. But why not add it back when using a DCF using FCFE. After all, excess cash is available for the equity holders if there is no debt. The reason we are using DCF in the first place is to find the cash flows that are available the providers of capital. If they are already sitting there on the balance sheet (they just have not been distributed) then why not add them back to your valuation.
Maybe an example will help make my point.
Suppose you are using a DCF with FCFE as your cash flow and there is no debt. You arrive at a value for equity of $600 million. Now, suppose the company has accumulated a lot of excess cash and has $300 million in CASH on the balance sheet. Should we add back this cash to our valuation. So: the value of equity is $900 million, rather than $600 million.
If we were using a FCFF model, we would add back the cash. i.e. if we discount FCFF (different firm) and get a value of $600 million, but the firm had $100 million in debt and $400 million in cash we would find the value of the EQUITY to be $900 million ($600 - $100 + $400).
 
maratikus Wrote:
——————————————————-
> i see Black Swan.
>
> In the formula FCFF = NetIncome + NonCash Charges
> + I*(1-t)- changes in fixed assets - changes in
> net working capital
>
> changes in net working capital exclude cash and
> debt. is that what you mean?
Excluding cash in net working capital is exactly right. After all, it is the cash flows you are trying to find.
 
ok Black Swan ..I see what you mean now…it makes sense…but like you said…then the excess cash should be added back to the DCF, no matter which method you use.
are there more problems in the CFAI text where they only add back cash to the FCFF DCF and not FCFE DCF?? If yes….then i’m gonna have to rip open that carton..and open the CFAI books!! (which I didn’t think i was ever going to get to !!)…but this needs to be clarified…because the schweser books don’t do it this way….
 
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