Topic 2 – Discounted Cash Flow – FCFE and FCFF

ISSUE 2– DATE 19 JULY 2015

This article attempts to discuss on some basic principles that should be considered to evaluate an investment in power plant deciding whether investment is a brown field or green field. First, I shall attempt to define only for the purpose of this article the meaning of brown field and green field.

1. INTRODUCTION AND OBJECTIVE

This article attempts to discuss on some basic principles that should be considered to conduct an equity valuation of an investment in power plant, whether for brownfield or greenfield, using discounted cash flow technique.  Two methods are available using the Discounted Cash Flow (DCF) namely, as follows:-

Method Explanation
Free Cash Flow to Equity (FCFE)

FCFE derives the equity value attributable to the equity project sponsors.

The Internal Rate of Return (IRR), as determined using the net cash flow from FCFE is known as the equity IRR.

Free Cash Flow to Firm (FCFF)

FCFF derives the enterprise value attributable to the stakeholders which comprise of both the equity and debt providers of a proposed power plant under evaluation.

The Internal Rate of Return (IRR), as determined using the net cash flow from FCFF is known as the project IRR.

2. METHOD OF VALUATION

Key differences between the two approaches, FCFE and FCFF are as follows:-

FCFE FCFF
1. Measurement FCFE measures the equity value of an independent power plant project,  to the equity contributors.

FCFE measures the Enterprise Value (EV) of an independent power plant project,  to the debt and equity contributors.

To arrive at the equity value, deduct the net debt from the EV. Mathematically, it can be presented as follows:-

Value of equity = EV – Net Debt

or

Value of equity = EV – ( Debt – Cash )

or

Value of equity = EV + Cash – Debt

2. Discount rate Uses the equity discount rate, Ke Uses the Weighted Average Discount Rate, WACC
3. Cash Flow The annual projected cash flow to be used prior to be discounted with the equity discount rate, is the net cash flow attributable to equity providers. The annual projected cash flow to be used prior to be discounted with the WACC, is the net cash flow attributable to equity and debt providers.
4. IRR, % The IRR so determined is actually the equity IRR, %. The IRR so determined is actually the project IRR, %.

THANKS FOR READING.

This article is prepared by Ong Tee Chin, CFA, FRM, and represents the view of the author. He can be contacted at ong@atlantiscapital.org for any further enquiries on the contents of this article.

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CERTIFICATION

Chartered Financial Analyst
CFA Institute



Financial Risk Manager
Global Association of Risk Professionals (GARP)

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