Effects of Financing Decisions on Future FCFF and FCFE

Dividends, share repurchases, and share issuance do not affect FCFF and FCFE. The reason for this is that FCFF and FCFE are cash flows available to investors, while dividends and share repurchases are uses of these cash flows. Therefore, the transaction between the company and its shareholders (through cash dividends, share issuances, and share repurchases) does not affect free cash flow.

Leverage changes will have a slight impact on FCFE but not FCFF. In the period that the debt is issued, FCFE will increase by the amount of debt issued. After that, FCFE will reduce by the after-tax interest expense.

If all the inputs were known, a DDM and an FCFE model would result in identical valuations for a stock. However, FCFE and dividends will differ, but the same economic factors that lead to high (low) dividends lead to high (low) FCFE. For example, if a company has many promising investment opportunities, it will reinvest and pay little in dividends. As a result, its fixed capital investments will be high, reducing the FCFE amount.

Question

Which of the following would most likely affect FCFE?

1. Dividends.
2. Debt increase.
3. Share repurchases.

Solution

The correct answer is B.

Debt increases will have an impact on FCFE. In the period that the debt is issued, FCFE will increase by the debt amount, and in subsequent periods it will reduce by the after-tax interest expense.

C is incorrect. Share repurchases are uses of cash flow but do not affect the amount of cash flow available to equity shareholders.

A is incorrect. Dividends do not affect the cash flow available to equity shareholders, but it is a use of the cash flows available to equity shareholders.

Reading 24: Free Cash Flow Valuation

LOS 24 (g) Explain how dividends, share repurchases, share issues, and changes in leverage may affect future FCFF and FCFE.