Free Cash Flow to Equity
Also written FCFE · Free Cash Flow to Equity (FCFE)
The cash left for shareholders after operating costs, tax, capital expenditure, working capital needs and all payments to lenders — what could be paid out as dividend without harming the business.
In plain language
FCFE is the money the owners could actually take home.
Start with the cash the business generated. Pay for the machines and buildings it must buy to keep running. Fund any increase in working capital. Pay the interest and the loan instalments due, and add back any new borrowing raised. What remains belongs to the shareholders — whether or not it is actually distributed.
How it works
The distinction from FCFF is which providers of capital have already been paid:
| Paid before the number | Discount at | Gives you | |
|---|---|---|---|
| FCFF | operating costs, tax, capex, working capital | WACC | Enterprise value |
| FCFE | all of the above plus interest and net debt repayment | Cost of equity | Equity value directly |
Because FCFE is already net of debt, discounting it gives the value of the equity. FCFF is not, so its discounted value is the whole firm, and debt must then be subtracted.
The formula
FCFF = EBIT × (1 − tax rate) + Depreciation − Capital expenditure − Increase in working capital
FCFE = Profit after tax + Depreciation − Capital expenditure − Increase in working capital
+ New debt raised − Debt repaid
A worked example
A steel fabricator for the year ended March:
| Line | Rs crore |
|---|---|
| Profit after tax | 310 |
| Add: depreciation | 145 |
| Less: capital expenditure | (230) |
| Less: increase in working capital | (85) |
| Add: new term loan drawn | 120 |
| Less: loan instalments repaid | (95) |
| FCFE | 165 |
The company reported a profit of Rs 310 crore but only Rs 165 crore was genuinely available to shareholders. The difference went into plant and into funding a larger order book.
If it paid a dividend of Rs 250 crore that year, it did not fund that dividend from the year's operations — it funded it from borrowings or from cash reserves. That is exactly the kind of finding a research report exists to surface.
Why NISM asks about it
Chapter 10 teaches both free cash flow measures and the rule about which discount rate each takes. Numerical questions commonly give you a partial list of adjustments and ask for FCFE, or ask which measure should be discounted at WACC.
Common exam traps
- FCFE takes the cost of equity, never WACC. Discounting FCFE at WACC double-counts the benefit of debt and overstates the value.
- Net borrowing is added, because raising debt puts cash in shareholders' hands this year. It is also why FCFE can be flattered by a company that simply borrows more.
- FCFE is not dividend. It is what could be paid; the dividend is what management chose to pay.
- An increase in working capital is a use of cash and is subtracted, even though it never appears as an expense in the P&L.
Check yourself
1.For which type of company is the Dividend Discount Model MOST suitable?
- a)Loss-making companies undergoing a turnaround
- b)Start-ups in a high growth phase
- c)Matured companies in defensive industries that pay regular and substantial dividends
- d)Companies that retain all earnings for reinvestment
Show the answer
Answer: (c) Matured companies in defensive industries that pay regular and substantial dividends
The workbook says DDM is suitable for companies that pay regular and substantial dividend, and therefore more suitable to matured companies in the defensive industry.
Option D describes exactly the situation where DDM fails — and the chapter gives the example: Alphabet Inc., the parent company of Google, has never paid a dividend. That is the whole reason the FCFE model exists as an alternative: it discounts the free cash flow available to equity shareholders instead of dividends actually paid.
Option B is wrong for a second reason too: a company in a high growth phase should not be valued on a constant growth assumption at all, because that growth is unsustainable in the long run and may even be higher than the cost of capital. Such companies need two-stage valuation.
Option A describes a company where EV/Sales is the appropriate metric — or, if no turnaround is likely, liquidation value.
Where this is taught
Free preparation for NISM Series XVRelated terms
- Core working capitalInventory plus trade receivables minus trade payables — the money permanently trapped in the operating cycle, stripped of cash and borrowings, which have nothing to do with trading.
- Discounted Cash FlowA valuation method that estimates the cash a business will generate in future years and converts each year back to what it is worth today.
- EBITDAProfit from running the business, measured before interest, tax, depreciation and amortisation — so before how the company is funded and how it accounts for its assets.
- Enterprise ValueWhat it would cost to buy the whole business — market capitalisation plus debt, less cash — as opposed to market capitalisation, which buys only the equity.
- Intrinsic valueWhat an asset is actually worth — the present value of the cash it will generate over its remaining life, as against whatever price the market is quoting today.