Free Cash Flow to Equity
Prof. Abhinav Sharma
Assistant Professor (Finance)
Goa Institute of Management
India
January 3, 2025
Computing FCFE
Free Cash Flow to Equity =
Net Income − (Capital Expenditures − Depriciation) −
(Change in Non cash working capital) + (New Debt Issued −
Debt Repayments)
Equity reinvestment = Capital expenditures − Depreciation +
Change in working capital − (New debt issued − Debt
repaid).
Equity Reinvestment
Equity Reinvestment Rate = Net Income
FCFE = Net Income − (Capital Expenditures −
Depriciation) − (Change in Non cash working capital) −
(Preferred Dividends − New Preferred Stock Issued) +
(New Debt Issued − Debt Repayments)
Choosing between DDM and FCFE
Dividends
Dividend Payout Ratio = Earnings .
Dividends+Equity Repurchases
Cash to Stockholders to FCFE = FCFE
If less than one, firm is paying out less dividends than they
can afford, using the same to increase its cash balance or
invest in marketable securities.
If greater than one, firm is paying out more and is drawing on
an existing cash balance or issuing new securities.
Constant Growth FCFE Model
FCFE1
Value = Cost of Equity −Forever Growth Rate
.
Common Rule of thumb, growth rate cannot exceed the
growth rate of the economy in which the firm operates.
Firms in their steady growth phase, may not have
significantly large differences in capital expenditure and
depreciation.
This model is best suited for firms growing at a rate lower
than the economy.
FCFE is a better model than DDM in this case if firms
paid very high or very low dividends relative to its FCFE.
Two-Stage FCFE Model
Value = PV (FCFE) + PV(Terminal Price).
Better model than DDM in this case if firms paid very high or
very low dividends relative to its FCFE.
If one gets significantly low value using 2 Stage FCFE,
Earnings are depressed due to some reason (economy
shock etc.)
Beta in the stable period too high for stable firm.
Working capital as % of revenue too high for stable firm.
Use of two-stage model when three stages was more
appropriate.
Two Stage FCFE...continued
If one gets significantly high value using 2 Stage FCFE,
Earnings are inflated above normal levels.
Capital expenditures are lower than depreciation during
high growth periods.
Growth rate in the stable growth period is too high for
stable firm.
Three Stage FCFE
High Growth phase vs Transition Phase vs Stable Growth
phase.
How firms’ characteristics differ w.r.t Capital spending, Risk,
Working capital, etc.
Best model to choose when the firm is undergoing very high
growth.
References
References I
