How do you use FCFE to evaluate different capital structure scenarios in capital budgeting?

Capital budgeting is the process of deciding which long-term projects to invest in, based on their expected cash flows and profitability. One of the key inputs for capital budgeting is the cost of equity, which reflects the return required by shareholders to invest in the company. However, the cost of equity can vary depending on the capital structure, or the mix of debt and equity financing, of the company. How can you compare different capital structure scenarios and their impact on the cost of equity and the value of the company? One way is to use FCFE, or free cash flow to equity, which is the cash flow available to shareholders after paying all expenses, taxes, interest, and debt repayments.

1 What is FCFE?

FCFE is the cash flow that belongs to the equity holders of the company, after deducting all the obligations to other stakeholders, such as creditors, suppliers, employees, and the government. FCFE can be calculated in different ways, but one common formula is:

FCFE = EBIT - Taxes - (Capital Expenditures - Depreciation) - (Changes in Net Working Capital) - (Net Borrowing)

EBIT is earnings before interest and taxes, which measures the operating profitability of the company. Taxes are the corporate income taxes paid by the company. Capital expenditures are the investments in fixed assets, such as machinery, equipment, or buildings. Depreciation is the reduction in the value of fixed assets over time. Changes in net working capital are the changes in the difference between current assets and current liabilities, which reflect the short-term liquidity of the company. Net borrowing is the net amount of debt issued or repaid by the company.

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Pann Koutsogkilas

Chief Financial Officer at F. H. Cann & Associates, Inc.
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The FCFE formula is as follows: FCFE = Net Income - (Capital Expenditure - Depreciation) - (Change in Net Working Capital) + (Net Borrowing) It is Net Income and not EBIT, because lenders need to be satisfied first (paying out the interest that they are owed) and the taxes need to be paid. The Net Borrowing is a plus, because a positive borrowing is in essence funds that could be used to pay equity (debt was already paid by accounting the interest). A practical example is that there have been companies that borrowed money and turned around and paid dividends with the funds. Not the best long term strategy, but it is a matter for a different conversation. A negative Net Borrowing is the case where the company repays debt principle.

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2 Why use FCFE?

FCFE is useful for evaluating different capital structure scenarios in capital budgeting, because it reflects the cash flow that can be distributed to shareholders as dividends or reinvested in the company. FCFE can be used to estimate the intrinsic value of the company's equity, by discounting the expected future FCFE by the cost of equity. The cost of equity can be estimated using various models, such as the capital asset pricing model (CAPM) or the dividend discount model (DDM). The cost of equity depends on the riskiness of the company's cash flows, which in turn depends on the leverage, or the amount of debt relative to equity, of the company. Higher leverage increases the financial risk and the cost of equity, but also magnifies the potential returns and the value of equity.

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John Clark

Executive Consultant at Club Benchmarking
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I like FCFE for capital planning because it is a more comprehensive calculation of an enterprise’s ability to fund reinvestment / capital returns. It allows to factor in the impact of existing leverage and can then help assess what further leverage is available.

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3 How to use FCFE?

To use FCFE to evaluate different capital structure scenarios in capital budgeting, you need to begin by estimating the current FCFE of the company, using either the formula or another method based on the historical financial statements and assumptions about the future growth and profitability. After that, calculate the cost of equity for the company by using a model such as CAPM or DDM, based on the current capital structure and market conditions. This cost of equity reflects the required return of shareholders to invest in the company. Divide the current FCFE by the cost of equity to get the present value of the company’s equity under this scenario. Repeat these steps for different capital structure scenarios, by changing the amount of debt and equity financing, and their corresponding interest rates and tax rates. Compare the present values of equity under each scenario, and choose one that maximizes the value of your company. This is your optimal capital structure balance between benefits and costs of debt and equity financing.

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John Clark

Executive Consultant at Club Benchmarking
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Excellent points. Ability to assess various scenarios and models can be insightful in determining optimal capital structure

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4 What are the limitations of FCFE?

FCFE is a useful tool for evaluating different capital structure scenarios in capital budgeting, however, it has some limitations. These limitations include FCFE's dependence on assumptions and estimates, such as the future growth rate, profitability, capital expenditures, working capital, and borrowing needs of the company. These assumptions may not be accurate or realistic and can change due to market conditions or other factors. Additionally, FCFE does not capture all the factors that affect the value of the company, such as intangible assets or strategic options. Moreover, FCFE does not account for agency costs or conflicts of interest that may arise between shareholders and managers due to different capital structure scenarios. Thus, FCFE should be used with caution and sensitivity analysis and should be complemented with other valuation methods. Additionally, it should be adjusted for agency costs or conflicts or consider alternative governance mechanisms.

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5 How to improve FCFE?

FCFE is an indicator of the financial health and performance of the company, and its ability to create value for shareholders. Therefore, improving FCFE can enhance the value of the company and its attractiveness to investors. To achieve this, you can increase the operating profitability and efficiency of the company by increasing revenues, reducing costs, optimizing processes, or innovating products or services. This can increase EBIT and reduce taxes, which are the main components of FCFE. Additionally, you can manage the working capital and capital expenditures of the company by aligning them with the operating cycle and strategic goals of the company. This can reduce cash outflows and increase cash inflows. Lastly, you can optimize the capital structure and financing decisions of the company by choosing an appropriate mix of debt and equity that minimizes the cost of capital and maximizes the value of equity. This can affect both FCFE and its discount rate, which determine the present value of equity.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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How do you use FCFE to evaluate different capital structure scenarios in capital budgeting?

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1 What is FCFE?

2 Why use FCFE?

3 How to use FCFE?

4 What are the limitations of FCFE?

5 How to improve FCFE?

6 Here’s what else to consider

Capital Budgeting

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