How do FCFF and FCFE differ?

• A. FCFF is cash flow to equity holders after debt payments; FCFE is cash flow to all capital providers
• B. FCFF is cash flow to debt holders only
• C. FCFE is cash flow to all capital providers
• D. FCFF is cash flow available to all capital providers before debt payments; FCFE is cash flow available to equity holders after debt payments and net new debt

Answer: (D)

The fundamental idea is that FCFF and FCFE measure cash that different groups of the company’s financiers can claim. FCFF, or free cash flow to the firm, represents the cash generated by the business that is available to all capital providers—both debt and equity—before any payments to debt holders are made. It reflects the cash left after operating activities, taxes, and the firm’s reinvestment needs, but before interest or principal repayments. FCFE, or free cash flow to equity, is what remains for the equity holders after meeting those debt obligations. It accounts for interest payments and principal repayments, and also includes the effect of net new borrowing (new debt issued minus debt repaid). In other words, increasing net debt boosts FCFE, while paying down debt reduces FCFE, all else equal.

So the correct concept is that FCFF is the cash flow available to all capital providers before debt payments, while FCFE is the cash flow available to equity holders after debt payments and after net debt changes. For reference, FCFE can be related to FCFF by adjusting for after-tax interest and net borrowing.