Why FCFF Excludes Interest for Enterprise Valuation

When we talk about valuing an entire enterprise, like a whole company, we often use a metric called Free Cash Flow to Firm, or FCFF. Think of FCFF as the total cash a business generates from its operations that is available to all its investors, both those who own debt and those who own equity. It’s like the total pie available to be split amongst everyone who has financed the company.

Now, financing costs, such as interest expense, are the payments a company makes for borrowing money. These are real costs and they definitely impact a company’s overall profitability and the cash available to equity holders, the shareholders. However, when we are calculating FCFF for enterprise valuation, we typically exclude interest expense. This might seem counterintuitive at first, so let’s break down why this is the standard practice.

Imagine you’re buying a house. The total value of the house, its enterprise value in a way, is determined by factors like its size, location, and condition. Your financing costs, like your mortgage interest, are separate from the inherent value of the house itself. The interest you pay depends on your loan terms and down payment, which are personal financial decisions, not inherent features of the house.

Similarly, when we value a company using FCFF to arrive at its enterprise value, we are trying to figure out the intrinsic value of the business operations themselves, independent of how the company is financed. We want to know how much cash the core business can generate, regardless of whether it’s funded primarily by debt or equity.

Interest expense is a consequence of a company’s financing decisions. A company might choose to use a lot of debt, resulting in high interest expenses, or it might choose to use very little debt, leading to low interest expenses. These financing choices are important, but they don’t change the underlying cash-generating ability of the business operations.

When we exclude interest expense from FCFF for enterprise valuation, we are essentially looking at the cash flow available to all capital providers before considering payments to any specific group, such as debt holders. This allows us to value the company as a whole, as if it were funded by a mix of debt and equity, and then later, in the valuation process, we account for the cost of debt and equity separately.

Think of it like this: FCFF is like measuring the size of the economic engine of the company. Interest expense is like measuring the cost of fuel for that engine, specifically the cost of borrowed fuel. When valuing the engine itself, we want to understand its potential output before factoring in the cost of a particular type of fuel.

Furthermore, the impact of financing costs is not ignored in enterprise valuation. It’s just accounted for in a different way, primarily through the discount rate we use when we project future FCFF and bring it back to the present value. This discount rate, often called the Weighted Average Cost of Capital or WACC, reflects the overall cost of funding the company, taking into account both the cost of debt and the cost of equity. The cost of debt within WACC inherently considers the interest rate companies pay on their borrowings.

So, in summary, we exclude interest expense when calculating FCFF for enterprise valuation because we want to assess the cash flow generated by the core business operations, independent of financing decisions. Financing costs are crucial, but their impact is incorporated into the valuation process through the discount rate, ensuring we value the enterprise as a whole, considering the contributions of both debt and equity financing. This approach gives us a clearer picture of the underlying economic value of the business itself, separate from the specific way it has chosen to fund its operations.