Discounted Cash Flow (DCF) Explained Step by Step
In Valuation Fundamentals - DCF, Multiples & Asset-Based Methods, you saw that Discounted Cash Flow is one of the core valuation approaches. The next interview question is usually more precise: what cash flow are you discounting, and at what rate? This lesson answers that by separating Free Cash Flow to Firm from Free Cash Flow to Equity, then proving the logic through a TCS-style cash flow calculation.
- Free Cash Flow is the cash available after maintaining and growing the business.
- FCFF, or Free Cash Flow to Firm, is cash flow available to all capital providers.
- FCFE, or Free Cash Flow to Equity, is cash flow available only to equity holders after debt-related adjustments.
- FCFF should be paired with WACC, or Weighted Average Cost of Capital, to value the firm in a DCF.
- FCFE should be paired with Cost of Equity to value equity directly.
- For a near debt-free company like TCS, FCFF is approximately equal to FCFE; for a leveraged company like Adani Ports, the difference is significant.
- In interviews, do not define Free Cash Flow as only net profit plus depreciation; explain operating cash flow, maintenance CapEx, and the FCFF vs FCFE distinction.
At a high level, DCF preparation is not about memorising one formula. It is about matching the correct cash flow with the correct investor group and discount rate.
The Context: What DCF Is Really Testing
A Discounted Cash Flow, or DCF, values a business by focusing on the cash it can generate for its capital providers. In interview settings, the interviewer is usually not only checking whether you remember a formula. They are checking whether you understand what kind of cash flow is being valued.
The source concept begins with a simple line: Free Cash Flow is the cash available after maintaining and growing the business. That line is important because it separates cash generation from accounting profit. Profit may include non-cash items, while Free Cash Flow tries to capture the cash left after reinvestment needs such as capital expenditure and working capital changes.
Free Cash Flow is the cash available after maintaining and growing the business; in DCF, the main decision is whether you are valuing cash flow for all capital providers using FCFF or cash flow for equity holders only using FCFE.
TCS: The Full Framework in One Business
TCS is a useful illustration because the source provides an approximate FY24 bridge from EBIT to FCFF and FCFE. It also shows a key DCF nuance: when debt is minimal, the firm-level and equity-level cash flows can be very close.
A shallow answer says only that TCS generated cash. A complete DCF answer explains why EBIT becomes NOPAT, why non-cash expenses are added back, why reinvestment is subtracted, and why FCFF is almost equal to FCFE when debt is minimal.
FCFF vs FCFE: The Core Comparison
The two versions of Free Cash Flow answer two different valuation questions. FCFF means Free Cash Flow to Firm, or cash available to all capital providers. FCFE means Free Cash Flow to Equity, or cash available only to equity holders after adjusting for debt costs and net borrowing.
The biggest conceptual rule is pairing. If you use FCFF, you are valuing cash flow available to all capital providers, so you use WACC, or Weighted Average Cost of Capital. WACC represents the blended return required by the providers of capital. If you use FCFE, you are valuing cash flow available only to equity holders, so you use Cost of Equity.
This is why the same business can be approached from two routes. The FCFF route values the firm first. The FCFE route values equity directly. In many interview answers, stating this pairing clearly is more important than writing the formula quickly.
Building FCFF Step by Step
FCFF starts from operating profit because it is meant to measure cash available to the firm before financing decisions. The formula from the source is: FCFF = EBIT × (1−T) + D&A − CapEx − ΔNWC.
In the TCS FY24 illustration, EBIT is ₹ 50,400 Cr and tax at 25% is ₹ 12,600 Cr. That gives NOPAT of ₹ 37,800 Cr. After adding Depreciation & Amortisation of ₹ 7,200 Cr, subtracting Gross CapEx of ₹ 4,500 Cr, and subtracting change in Net Working Capital of ₹ 1,800 Cr, FCFF comes to ₹ 38,700 Cr.
FCFF = EBIT × (1−T) + D&A − CapEx − ΔNWC.
Building FCFE Step by Step
FCFE begins after FCFF and then adjusts for debt-related cash flows. The formula from the source is: FCFE = FCFF − Interest × (1−T) + Net Borrowing. This is because equity holders receive cash after debt costs and after considering whether the business has raised or repaid debt.
For TCS, Interest × (1−T) is shown as ₹ 0 because TCS is near debt-free. Net Borrowing, calculated as new debt minus repaid debt, is ₹ -200 Cr. Therefore, FCFE is ₹ 38,500 Cr after starting from FCFF of ₹ 38,700 Cr.
FCFE = FCFF − Interest × (1−T) + Net Borrowing.
The interpretation matters. TCS has minimal debt, so FCFF is approximately equal to FCFE. For a leveraged company like Adani Ports, the source notes that the difference is significant. That is because interest and net borrowing can materially change the cash actually available to equity holders.
Worked Example: TCS FY24 Cash Flow Bridge
Consider the interview situation: you are asked to explain DCF using actual cash flow logic rather than a memorised formula. The problem is to move from operating profit to the cash flow available for valuation, then decide whether FCFF or FCFE is the right measure. The framework is the FCFF to FCFE bridge.
The decision from this bridge is clear: if valuing the firm, use FCFF of ₹ 38,700 Cr with WACC; if valuing equity directly, use FCFE of ₹ 38,500 Cr with Cost of Equity. The learning is that the correct DCF answer is not just the final number. It is the logic connecting operating profit, reinvestment, leverage, investor claim, and discount rate.
Maintenance CapEx vs Growth CapEx
The source gives a specific interview warning: if asked what Free Cash Flow is, do not just say net profit plus depreciation. A stronger answer says Free Cash Flow is operating cash flow minus maintenance CapEx. Maintenance CapEx means capital expenditure required to maintain the existing business, while growth CapEx is capital expenditure intended to expand the business.
This distinction matters because growth CapEx should not be subtracted from maintenance FCF. The source highlights that this becomes especially important in Leveraged Buyout models, or LBO models, where Free Cash Flow drives debt repayment. In that context, confusing maintenance and growth spending can distort how much cash is available to repay debt.
Choosing the Right Cash Flow and Discount Rate
In practice, the interviewer may test whether you can connect the cash flow type to the valuation purpose. The rule is direct: FCFF goes with WACC to value the firm; FCFE goes with Cost of Equity to value equity directly.
A useful nuance is that the choice is not about which formula looks easier. It depends on what you are valuing. For firm value, FCFF is the natural route. For equity value directly, FCFE is the natural route. In companies with more leverage, the FCFE path requires much closer attention to after-tax interest and net borrowing.
Structuring a Discounted Cash Flow (DCF) Explained Step by Step Interview Answer
"Walk me through Free Cash Flow in a DCF and explain when you would use FCFF versus FCFE."
The number one way candidates get this wrong is by mixing the cash flow and discount rate. If you use FCFF, say WACC; if you use FCFE, say Cost of Equity.
Do not define Free Cash Flow as simply net profit plus depreciation! That misses maintenance CapEx, working capital, and the FCFF versus FCFE distinction. It also costs points because the interviewer cannot see whether you understand which cash flow belongs to which capital provider.
Conclusion
DCF becomes much clearer when you stop memorising formulas and start tracking who the cash flow belongs to. FCFF values cash available to all capital providers using WACC, while FCFE values cash available to equity holders using Cost of Equity; the TCS bridge shows how that logic works step by step.