Contrast what FCFF, FCFE, dividend and residual income models each need as inputs
The idea
Discounted cash flow models differ mainly in which cash flow they discount and at what rate. The dividend discount model uses forecast dividends at the cost of equity, which suits steady payers. The free cash flow to equity model uses cash left for shareholders after investment and net borrowing, FCFE = CFO - FCInv + net borrowing, also at the cost of equity. The free cash flow to firm model uses cash available to all capital providers at the weighted average cost of capital, giving firm value, from which debt is subtracted to reach equity. The residual income model starts from current book value and adds the present value of earnings above the equity charge, RI = (ROE - r) x beginning book value. Matching cash flow and discount rate is what keeps each model consistent.
A practice question
Free cash flow to the firm is discounted at the:
- weighted average cost of capital — correct
- required return on equityWhy not: The cost of equity matches FCFE, which is the cash flow left for shareholders only.
- yield on government bondsWhy not: A risk-free government yield ignores the risk borne by the providers of capital to the firm.
FCFF is cash available to both debt and equity holders, so it is discounted at the WACC, which blends their required returns. The result is firm value, from which debt is subtracted to find equity value.
A harder one
A company reports cash flow from operations of 900, fixed capital investment of 350 and net borrowing of 120. Its free cash flow to equity is:
- 430Why not: Subtracting net borrowing. New borrowing is cash that becomes available to shareholders, so it is added.
- 550Why not: Ignoring net borrowing, which gives FCFE only for a firm with no change in its debt.
- 670 — correct
FCFE = CFO - FCInv + net borrowing = 900 - 350 + 120 = 670.
The hardest tier
A company pays no dividends and has negative free cash flow because of heavy investment, but it is profitable and has positive book value. The most suitable model is the:
- dividend discount modelWhy not: With no dividends there is nothing to discount, so the value would rest entirely on a distant, guessed payout.
- FCFE modelWhy not: Negative free cash flow for years pushes nearly all the value into the terminal value, where it is least reliable.
- residual income model — correct
The residual income model uses book value and earnings, both available and positive here, so more of the value is recognised early and depends less on a long-dated terminal estimate.
In the app: 6 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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