4. Project valuation through FCFF

In a simple world, an investor would put his or her money on a company, which in turn, through its operational activity would generate a profit and the investor would collect the entire net income in the form of dividends.

But the world is not so simple:

  • Net income is not equal to the cash that is generated through an economic activity.
  • Companies need to reinvest in order to keep competitive.
  • Companies retain most earnings, which means that dividends do not correspond to the net income.
  • Dividends payment policy is related to more than jut the net income. It can be somehow erratic and detached from the company’s performance.
  • The payout ratio varies within industries.
  • Most private companies do not pay dividends to the equity holders.
  • Companies get their financing from both equity and debt and the entirety of the debt service has to be in the equation.

Hence, in most situations (specially in private companies) the economic benefits of capital holders cannot be directly inferred by either the net income or by the dividends that the company pays. The solution is to use the economic benefits that the company generates: the Free Cash Flow (FCF).

The FCF is the cash that the company makes available for the holders of the company’s capital through its operational, financing and investment activities. The cash flows are the economic benefits of those who have invested in the company. The income statement only presents the revenues and expenditures; it does not identify the entries and withdrawals of cash and, on top of it, the income statement includes items that do not represent any cash movement, as is the case of the depreciations.

Since there are two types of holders of capital (equity holders and debt holders), the FCF of a firm is commonly calculated under two perspectives:

  • FCFF (Free Cash Flow to the Firm) – the cash flows that are available for both the debt holders and the equity holders.
  • FCFE (Free Cash Flow to Equity) – the cash flows that are only available for the equity holders.

Because there may be different grades of equity holders, just consider that the FCFE corresponds to the holders of ordinary capital.

It is important to always take in consideration the distinction between FCF, FCFF and FCFE, as it can induce in errors. The FCF may be a reference to either the FCFF or the FCFE without any particular discrimination of which.

The processo of valuing a company or project by FCF, FCFE or FCFF is not completely the same, nor does it use the same assumptions (despite being similar). By using the FCFF you will reach to the business value, using the FCFE while bring you to the equity value. Since there are two forms of capital it is easy to understand the relation between business value and equity value:

  • \({Company\ value }= {Equity\ value + Debt\ value}\)

The calculation of the FCFF is based on information that can be retrieved from the financial statements of a company. It is common to start from:

  • the EBITDA.
  • the EBIT.
  • the net income.

Independently of which item you start of, you must always attain the same FCFF.

From the EBIT to FCFF

  • \(FCFF=EBIT\left(1-t\right)+NCC-\mathrm{\Delta WCI}-Inv\)


  • EBIT: earnings before financing costs and taxes.
  • t: the corporate income tax.
  • NCC: net non-cash charges.
  • Δ WCI: variations on the working capital investment.
  • Inv: Investment in fixed assets.

The NCC is the net balance of the gains and losses that do not reflect any cash flow. Typically, the depreciations are the main components of the NCC. However, there are other items that can be considered as NCC, such as:

  • Internal projects.
  • Impairment of inventories (losses or reversals).
  • Impairment of receivables (losses or reversals).
  • Provisions (increases or reductions).
  • Impairment of investments not depreciable/amortizable (losses or reversals).
  • Impairments-other (losses orreversals).
  • Increases or reductions in fair value.
  • Impairment of depreciable/amortizable investment (losses or reversals).

Most literature normally refers only to depreciations and provisions without references to other NCC. However, to not account for other NCC accounts can lead to deviations of the FCFF which can influence the valuation of a project or company.


A valuator may encounter a situation in which the financial statements feature singularities that are most likely to not occur in the following years, such as:

  • Investment in non-operating assets.
  • Farm subsidies.
  • Impairments (it is important to retain that although impairments be deducted in calculating the FCFF, can take effect in later years).

The decision to carry out adjustments derives from the need to obtain the FCFF generated by the company that is a consequence of the normal activity. A company that has large amounts of cash will be able to invest it (the very least the the company will receive interest from deposits). But the income and cash flows generated by this investment are not related to the activity of the company and could be easily replicated by the holders of capital if the company distributed dividends.

Example – Correcting FCFF

Take a factory that has been hit by a fire with a permanent loss of part of its machinery within a net worth of 245.000€. The company will register an impairment of the loss of this asset by this amount. The impairment recorded does not correspond to a release of cash and thus should not directly affect the cash-flow of the company.

From the EBITDA to FCFF

Getting to the FCFF starting on the EBITDA is similar to the EBIT.

  • \(FCFF=EBITDA(1-t)+(NCC)(t)-\mathrm{\Delta WCI}-Inv\)


  • EBITDA: earnings before depreciation, financing costs and taxes.
  • t: the corporate income tax.
  • NCC: net non-cash charges.
  • Δ WCI: variations on the working capital investment.
  • Inv: Investment in fixed assets.

From the net income to FCFF

The FCFF can also be obtained through the net income.

  • \(FCFF=NI+NCC+D(1-t)-\mathrm{\Delta WCI}-Inv\)


  • NI: net income.
  • D: Debt.

Analysis of the FCFF

Always remember that the FCFF are not dividends or cash that was indeed paid to the holders of capital. It is available, meaning that it can be used to pay equity holders and debt holders whenever necessary. If not paid, the FCFF will accumulate within the company until debt and interest payment or dividend distribution takes place.

Despite being stated as the value that can be made available to holders of capital, the FCFF may be positive or negative. A positive FCFF means that the company is accumulating financial flows that can be distributed. A negative FCFF reduces the overall amount of funds that can be made available to holders of capital. A non-recurring negative FCFF does not imply a need for extra financing; if the company has sufficient resources, it will not need to refinance. However, constant negative financial flows through several periods will lead to an increase of the company’s financing.