FCFE

CFA Level I Equities
#1

I am unable to understand why Net Borrowing is added to FCFE.

FCFE = FCFF - [Int x (1-tax rate)] + Net Borrowing.

If the company, say, goes bankrupt, the bondholders will be the first ones to get their money back. Essentially, this borrowed money doesn’t belong to equity holders, so why are we including it as part of FCFE? I’m curious. Shouldn’t we subtract net borrowing from FCFE because it doesn’t belong to them?

I’d appreciate any thoughts.

#2

If you borrow money today, absent covenants to the contrary, you could pay it all as a dividend tomorrow.

#3

Thanks S2000magician for your help. On the contrary, if they want their money back, shareholders would have to take a hit somewhere else–stock price, or dividends. Isn’t it? The money doesn’t belong to them in reality. I am still unclear. I’d appreciate if you could share your thoughts.

#4

The money belongs to the company to do with it as they please until they’re obligated to repay it. They can pay it to the shareholders if they choose.

You may not like the reasoning, but that’s what the reasoning is, good or bad.

#5

Thanks S2000magician :slight_smile:

#6

You’re welcome.

#7

Remember that we’re talking about Free Cash FLOW, and a flow measure usually implies “flow over some period”. In this case, we’re usually talking a year’s time. So, for FCFE, we’re calculating the cash flow that’s generated and available to shareholders IN A GIVEN YEAR.

What the firm does with the cash flow is another issue - as Magician said, it could be paid out in a dividend.

Of course, the debt might be paid back next year. But that’s not FCFE for THIS year - that would impact FCFE for the year in which the debt was repaid.