Free Cash Flow: FCFF vs FCFE Explained
After the Enterprise Value Bridge Explained, the next question is what cash flow the valuation is actually discounting. Free Cash Flow matters because it moves from accounting profit to cash available after maintaining and growing the business. In interviews, the key is not just knowing the formula, but knowing why FCFF values the whole firm while FCFE values only equity.
- Free Cash Flow is the cash available after maintaining and growing the business.
- Two versions exist: FCFF for all capital providers and FCFE for equity holders only.
- FCFF = EBIT × (1-T) + D&A - CapEx - ΔNWC.
- FCFE = FCFF - Interest × (1-T) + Net Borrowing.
- FCFF is used with WACC to value the firm in a DCF, while FCFE is used with Cost of Equity to value equity directly.
- TCS has minimal debt, so FCFF ≈ FCFE. For a leveraged company like Adani Ports, the difference is significant.
- If asked "What is FCF?", do not just say net profit + depreciation. Show the distinction between Operating cash flow - Maintenance CapEx and total CapEx.
Free Cash Flow in Valuation
Free Cash Flow is a valuation-ready cash metric because it focuses on cash available after maintaining and growing the business. The big picture is simple: FCFF is for all capital providers, while FCFE is for equity holders only.
When to use which: FCFF - use with WACC to value the firm (DCF). FCFE - use with Cost of Equity to value equity directly.
Free Cash Flow is the cash available after maintaining and growing the business.
FCFF = EBIT × (1-T) + D&A - CapEx - ΔNWC
FCFE = FCFF - Interest × (1-T) + Net Borrowing
TCS: Free Cash Flow Build in One Business
TCS FY24 shows how the FCFF to FCFE bridge works when a company has minimal debt. The operating cash build starts with EBIT, adjusts for tax, adds back non-cash depreciation and amortisation, subtracts capex and working capital change, and then adjusts for debt costs and net borrowing.
TCS has minimal debt, so FCFF ≈ FCFE. For a leveraged company like Adani Ports, the difference is significant.
Note: All figures are illustrative/approximate and for educational purposes only.
Why Debt Levels Change the Answer
FCFF is before financing cash flows because it is for all capital providers. FCFE moves from firm-level cash flow to equity-level cash flow by subtracting after-tax interest and adding net borrowing.
This is why debt levels matter. TCS is near debt-free, so the adjustment from FCFF to FCFE is small. For a leveraged company like Adani Ports, the difference is significant.
Maintenance FCF vs Growth CapEx
If asked "What is FCF?", do not just say net profit + depreciation. Show you understand: FCF = Operating cash flow - Maintenance CapEx (not total CapEx).
Growth CapEx should NOT be subtracted from "maintenance FCF" - this distinction matters in LBO models where FCF drives debt repayment.
DCF in One Line: Equity Value = Sum of [FCFF discounted at WACC] + [Terminal Value discounted at WACC] - Net Debt
Structuring a Free Cash Flow Interview Answer
"What is FCF?"
The strongest answer shows that FCFF and FCFE are valuation choices, not just formulas. Tie FCFF to WACC and firm value, tie FCFE to Cost of Equity and equity value, then explain why debt makes the two diverge.
The most frequent error is saying FCF is just net profit + depreciation. That misses the capex and working capital adjustments, and it also misses the maintenance FCF nuance: Growth CapEx should NOT be subtracted from "maintenance FCF" because this distinction matters in LBO models where FCF drives debt repayment.
Conclusion
Free Cash Flow is the cash available after maintaining and growing the business. FCFF values the whole firm using WACC, FCFE values equity directly using Cost of Equity, and the gap between them becomes especially important when debt levels change.