Reconciling FCFF and FCFE in Nominal and Real Models

Abstract

The objective of this paper is to reconcile Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE) approaches, in nominal and real term models, considering potential and actual distribution. In order to do so, some mathematical derivations are made to help reconciliation, especially in real term models. In addition to that, application of both approaches, in nominal and real models, are developed through full examples. Two discussions are addressed: (1) valuation approaches inconsistency debate, to which there are two possible corrections in order to assure that inputs (in capital structure) in both approaches reflect the same assumptions and (2) potential versus actual distribution debate, which considers that the firm does not distribute all cash available for distribution. To reconcile nominal and real term models, there is necessary caution to assure that the tax shield over the inflation embedded in the nominal cost of debt is considered in the real model. When considering actual distribution, there are additional necessary adjustments to calculate real term earnings consistent with nominal earnings, in order to reconcile both models.