Question 18.ss.3: How do the cash flows that are discounted when the WACC appr...

Fundamentals of Corporate Finance

How do the cash flows that are discounted when the WACC approach (FCFF approach) is used to value a business differ from those that are discounted when the free cash flow to equity (FCFE) approach is used to value the equity in a business?

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The cash flows that are discounted when the WACC approach is used to value a business are calculated in the same way that the cash flows are calculated for a project analysis. These cash flows represent the total cash flows that the business is expected to generate from operations. The cash flows that are discounted when the FCFE approach is used are the total cash flows from the business that are available for distribution to the stockholders. In other words, they equal the total cash flows that the business is expected to generate less the net cash flows to the debt holders. The net cash flows to the debt holders is equal to the interest and principal payments that the firm makes less any proceeds for the sale of new debt.

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