Question

Distinguish between the following discounted cash Flow valuation models 1) Free Cash flow to equity and 2 Free Cash flow to the firm

Answer 1

Free cash flow models can be further categorized into two types. There are certain kinds of models which pertain to free cash flow that the firm as a whole will generate whereas there are others that pertain solely to the perspective of equity shareholders. These models are different from each other and should use them in appropriate circumstances to make best use of it.

BASIS	FREE CASH FLOW TO EQUITY	FREE CASH FLOW TO FIRM
MEANING	It is the amount of cash flow that accrues to equity shareholders after all the operating, growth, expansion and even financing costs of the company have been met.	This is the amount of cash flow which is available to all the investors of the firm which would typically include bondholders (debt) as well as shareholders (equity). The cash flow being considered here is operating cash flow and is generated by using the operating assets of the firm. If there are other assets like cash, marketable securities or any other kind of investments which are not used in day to day operations, their discounted present value needs to be added separately to the value of the firm as they are not considered in the free cash flow to the firm metric.
DISCOUNT FACTOR	Since FCFE pertains only to equity shareholders, it needs to be discounted at a rate which reflects its level of risk. The risk of being an equity shareholder is higher than the risk of the entire firm if the firm is leveraged. Thus, the appropriate discount factor for these cash flows will be expected return on equity. FCFE must be discounted at the expected cost of equity.Discounting the wrong cash flow with the wrong discount factor will lead to wrong valuation.	Since the cash flow in FCFF pertains to the entire firm, it must be discounted at the weighted average cost of capital i.e. WACC. The idea is that the costs of debt and equity must be combined in the exact proportion in which they are being used. Also, tax benefits arising because of usage of debt are to be considered.
FORMULA	The value of a firm’s equity can be calculated in one of these two way: 1) By discounting all the future free cash flows to equity at return on equity. Value (Firm's Equity) = ?FCFE/ (1+(Return on Equity))^n 2) By subtracting the discounted present value of debt from the discounted present value of the firm. Value (Firm’s Equity) = Value (Firm) – Value (Firm’s debt)	The formula for calculating the value of the firm using FCFF approach is as follows: Value (Firm ) = ? FCFF/ (1+(WACC))^n