Now that we have a general understanding of calculating the free cash flow for both the firm and equity holders, let us move on to assessing the return expectations from each perspective.
To gain insight into what the debt holders of the firm expect in return, it is important to understand that they seek an interest payment against the principal amount and, ultimately, repayment of said principal at the end of tenure.
When it comes to the firm’s free cash flow, it must meet the return expectations of both the debt and equity holders. Consequently, a valuation model based on FCFE will discount the cash flow with a blended rate calculated to satisfy both parties.
An illustration to explain this; considering a company with a 350Cr capital structure, where debt holders own 125Cr and equity holders the balance of 225Cr. The debt holders expect a 9% return, while the equity holders seek a 15%. We will look into why they anticipate such outcomes later on. But from the firm’s perspective, it should be producing a blended return which suits both parties – that is the weighted average return.
= (9%*125) + (15%*225) / 325
The blended rate of return is referred to as the Weighted cost of capital (WACC), which we will cover later.
The equity holder’s return expectation is referred to as ‘the cost of capital’. This cost must be at least equal to the prevailing risk-free rate of the economy due to them taking on an additional risk above that of debt holders. Consequently, they need a higher return than debt holders in order to justify their investment.
Cost of capital = Risk-free rate + Risk premium
In this chapter, I’ve covered the basics of FCFF and FCFE and their associated return expectations. In our next chapter, let’s take a closer look at these topics. We should note that the cost of capital will always be higher than the WACC.