The superiority of FCFF over EVA and FCFE in capital budgeting

Abstract

Misapplication and misinterpretation of capital budgeting techniques can lead to serious capital allocation and capital structure problems. Mainstream literature suggests at least ten approaches for free cash flow and discount rate estimation (leading to the same net present value -NPV) but their benefits vary a lot. We emphasise the application risks when using these techniques without considering the cost of capital for the whole company, thus leading to value decreasing investment decisions. A comparative analysis with a classical free cash flow to equity (FCFE) and economic value added (EVA) methodology will make a strong case for free cash flow to firm (FCFF) as the most efficient approach. We also shed additional light on the main risks associated with the FCFE technique and project-based weighted average cost of capital (WACC) in the capital budgeting process.

Distributing Enterprise Value to Stakeholders in the Range of Sustainable Development on the Basis of the Energy Industry in Poland

“…In the source literature, the role of cash flow reporting is increasingly emphasised as one of the basic sources of information in the decision-making process regarding the enterprise's activities [53][54][55][56]. However, until now, cash flow has not been used in business practice as a tool for measuring sustainable value, i.e., value for the enterprise's stakeholders.…”

Aplikacja koncepcji zarządzania wartością VBM w publicznych instytucjach kultury

“…nr 3(27)2020 Kalkulacja przepływów na potrzeby wyceny instytucji kultury W celu wyceny przedsiębiorstwa metodami dochodowymi konieczne jest oszacowanie przyszłych przepływów pieniężnych, a następnie zdyskontowanie uzyskanych wartości na dzień wyceny. Kalkulacje przepływów pieniężnych można przeprowadzić, stosując w tym celu metodę FCFE, zgodnie z którą formuła pozwalająca na wyznaczenie przepływów pieniężnych przyjmuje następujący kształt (Mielcarz, Mlinarič, 2014):…”

Valuation of renewable energy investments: an explanatory mixed-methods study about applied approaches amongst practitioners

“…An extensive literature review 3 reveals that the majority of public theoretical approaches and empirical studies about valuation focus mainly on numerical methods and less on qualitative and judgmental approaches, even though the latter is at least as essential in valuation processes (Damodaran, 2012). From the perspective of numerical approaches, Table 1 presents an overview of the available valuation methodologies, of which discounted cash flow (DCF)-based ones and the economic added value (EVA) method are the most popular and essential approaches both in literature and in practice (Baker et al, 2010;Mielcarz and Mlinarič, 2014). Since the EVA approach is seldom applied for valuating RES-E investment projects 4 , the focus of this research is on DCF-based approaches.…”

“…Ehrhardt and Brigham (2016) propose an integrated framework, combining numerical and judgmental aspects of risk assessment in valuation; it considers the effects of the investment in a new project on the investing company and the investor, based mainly on judgmental evaluations. Mielcarz and Mlinarič (2014) in italic letters.…”