Free Cash Flow Valuation

### Section: Free Cash Flow Valuation Estimated study time: 60 minutes Content: Exam weight (2026 curriculum): Equity Investments — 10–15% of the CFA Level II exam (one of four topics at the 10–15% band, alongside FSA, Fixed Income, and Portfolio Management). Source: CFA Institute Level II Exam page, fetched 2026-06-29. Free cash flow valuation (FCFF/FCFE) is the technically deepest equity valuation topic at Level II and frequently anchors a full vignette with multi-step calculations. Free cash flow valuation models are among the most technically rigorous equity valuation approaches tested at CFA Level 2. Unlike dividend discount models, free cash flow models do not depend on dividend policy — they value the cash generated by the business that is available to be distributed to investors. Two primary free cash flow measures are used: FCFF (Free Cash Flow to the Firm) is the cash available to all capital providers (debt and equity) after operating expenses and capital investment needs are met; FCFE (Free Cash Flow to Equity) is the cash available to equity holders specifically, after all debt obligations are satisfied. The choice between FCFF and FCFE depends on the target's capital structure stability, debt management, and whether the analysis is from the firm's or equity investor's perspective. FCFF is computed from operating income: FCFF = EBIT*(1-t) + Depreciation - Capital Expenditures - Change in Working Capital. Alternatively, starting from net income: FCFF = Net Income + Depreciation + Interest*(1-t) - Capital Expenditures - Change in Working Capital (adding back the after-tax interest expense because interest is a payment to debt providers,…