Lesson 9 of 11 · All lessons in this module
- Present value models: DDM and FCFEVideo lesson
- Choosing the cash flow: dividends or FCFE
- FCFF, EBITDA and residual income
- Preferred stock and the Gordon growth modelVideo lesson
- Multistage dividend discount modelsVideo lesson
- Growth assumptions for any cash flow: constant, implied and two-stage
- The DCF process: discount rates, terminal values and ranges
- Integrated cases: negative growth and reconciling FCFE with FCFF
- Integrated cases: two-stage FCFF with debt, and the effect of the debt ratio
- Shortcomings of constant and multistage growth models
- Preferred shares: required return and contingency features
This lesson is part of the 2027 curriculum. You are following the 2026 curriculum, where it is not taught in this form. Switch if you are sitting the exam under the 2027 curriculum.
Lesson 9 of 11 · 16 min
Integrated cases: two-stage FCFF with debt, and the effect of the debt ratio
A two-stage FCFF model discounts at WACC to a firm value from which debt is deducted before dividing by shares; and when the target debt ratio changes, FCFE moves a lot while FCFF barely changes.
In short
- Two-stage FCFF: PV of the stage-1 cash flows plus the PV of the terminal value, all at WACC; the result is a firm value.
- Equity = firm value − market value of debt (and preferred); only then divide by shares. Discounting at r_e gives a wrong, much lower firm value.
- FCFE = NI − (1 − DR)(FCInv − Dep) − (1 − DR)ΔWC: a higher target debt ratio DR raises FCFE for given investment.
- FCFF = CFO + Int(1 − t) − FCInv; implied net borrowing = FCFE + Int(1 − t) − FCFF = DR × net investment.
- FCFF is nearly unaffected by the debt ratio (only the tax shield on interest changes); FCFE responds strongly.
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