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Free Cash Flow Defined: FCFF vs FCFE and Which Discount Rate Fits Each
· Background
dcf cash-flow valuation
'Free cash flow' means two different things depending on whose cash it is. This post defines free cash flow to the firm and to equity, shows how each is built, and explains which discount rate pairs with which.
Equity cash flows discounted at WACC, or firm cash flows at the cost of equity — the mismatch that produces wrong values
Discounting FCFE at WACC or FCFF at cost of equity mismatches the owner of the cash flow and the providers represented by the rate. The arithmetic still runs, so this error can look polished. Start by naming the claim being valued; only then choose the rate and the bridge that follow.
Free cash flow to the firm — cash available to all capital providers, computed before interest and after reinvestment
FCFF is cash available to all capital providers after operating tax and reinvestment but before financing payments. A common construction begins with after-tax EBIT, adds non-cash charges and subtracts capital expenditure and working-capital investment. ToolAcre’s source explicitly describes its projected cash flows as unlevered FCFF.
Free cash flow to equity — cash left for shareholders after interest, debt repayment and new borrowing
FCFE is cash remaining for shareholders after interest and net debt flows as well as operating reinvestment. New borrowing can increase it and debt repayment can reduce it. Because financing is inside the cash flow, FCFE does not require the same net-debt bridge after discounting that FCFF does.
The pairing rule — FCFF with WACC yields enterprise value; FCFE with the cost of equity yields equity value directly
The pairing rule follows ownership: FCFF discounted at WACC yields enterprise value, then debt minus cash is subtracted to reach equity. FCFE discounted at cost of equity yields equity value directly. Swapping rates changes both risk representation and the meaning of the resulting total.
Why the two approaches should agree — and the leverage and financing assumptions that make them diverge in practice
In a fully consistent model, the two approaches can reconcile after financing assumptions are aligned. In practice they diverge when debt changes through time, borrowing and repayment forecasts differ, or a single WACC assumes a capital structure unlike the FCFE schedule. The difference is an audit question, not a reason to average results.
Worked example — one set of invented statements turned into both FCFF and FCFE, with the cash flows lined up side by side
For a hypothetical operating year, after-tax EBIT of 120 plus depreciation of 40 minus capital spending of 55 and working-capital investment of 15 gives FCFF of 90. Moving toward FCFE would then incorporate after-tax interest and net borrowing. Those added lines must come from a financing schedule, not from the DCF engine.
What this does not cover — the calculator does not know which definition you used; the pairing is your responsibility
The tool cannot infer which definition a user intended from a number. It validates positive starting FCF and calculates a net-debt bridge. The documented implementation is FCFF-based, so entering FCFE while retaining WACC and the bridge would double-count financing effects even though every field passed numeric validation.
Define the cash flow before you pick the rate — ToolAcre is documented for unlevered FCFF, not an arbitrary series
The original heading said ToolAcre discounts whichever series it receives. Its source is more specific: unlevered FCFF produces enterprise value. Use that supported path and keep FCFE analysis in an equity-cash-flow model. Consistency of claim, rate and bridge matters more than which method gives the preferred number.