FCFF vs FCFE and Interest Expense - DCF Dilemma
Hi,
I was recently reviewing the IB guide of hard questions from Wall Street Prep and came across the difference of UFCF and LFCF. What puzzles me is that by using UFCF and then subtracting net debt to derive equity value, the interest expense is not accounted for - as we use NOPAT to compute FCF.
This leaves a hole as in reality interest expense is very real and a cash one, which lowers equity value.
So why should this yield the same equity value as using FCFE, which indeed takes into account interest expense but is rather more boring to put together?
Thanks.
By subtracting net debt from enterprise value to derive equity value, you already indirectly account for interest expense.
If you use the FCFE method, you include the interest expense in the cash flows, but you don’t have to address net debt because the discounted value is already equity value.
Levered DCF uses a discount rate that is equal to the cost of equity. i.e FCFE approach
Unlevered DCF uses a discount rate that is equal to the weighted average cost of capital (inclusive of debt AND equity cost) your WACC should be typically lower that your cost of equity.
Interest cost directly impacts cost of debt which impacts WACC therefore your UFCF DCF valo implicitly inlcudes your interest expense
As you said, WACC is lower than cost of equity so is not penalizing the EV for an higher interest expense.
The comment below makes more sense, when subtracting part value of the debt you are accounting for future interests as par value is the PV of future principal and interest discounted at the coupon rate.
When you subtract the par value of debt you are also subtracting future interest expense at the same time because par is equal to the PV of future interest and principal payments discounted at the debt’s coupon rate.
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