An investor looking to buy an equity portion of a start up – can value only the free cash flows returned to equity. She/He would be interested in the gains they can expect by buying the equity. It is then – equity valuation of net cash flows discounted at cost of equity.
It is not the case for enterprise valuation – where the entire company is valued including the equity, debt and investments. Enterprise valuation considers the free cash flows expected to be generated to the firm, not just to equity component. The cash flows would be discounted by the cost of capital/financing (which includes both the debt and equity).
Free Cash Flows to the Firm (FCFF) denotes the net cash available from the operating income post paying out the taxes and reducing any reinvestments. Reinvestments are arrived from the net capital expenditure & changes in non-cash working capital. This capital denotes the cash left after taxes and reinvestments, but before paying interest and principal for the debt.
FCFF = (Operating Income post tax) minus (Net Capital Expenditure) minus (Changes in non-cash working capital)
Free Cash Flows to Equity (FCFE) denotes cash left after taxes, reinvestments and the interest/principal obligations for debt.
FCFE = (Net Income) plus (Depreciation) minus (Reinvestments) minus Debt Cash Flows
FCFE considers net income instead of operating income as the other non-operating expenses like interest payments need to be considered. We add back the depreciation as it is an accounting expense for tax obligations, but not an actual cash expense. Debt Cash flows include the principal payments paid and any new debt secured.
FCFF and FCFE can be discounted at their discount rate, cost of capital and cost of equity correspondingly to arrive at the net present value.
