What is the correct interpretation of the relationship between FCF and EV in a DCF?

What is the correct interpretation of the relationship between FCF and EV in a DCF?

• A. EV is the PV of FCF, using WACC
• B. EV equals sum of cash flows without discounting
• C. EV equals discounted tax shield
• D. EV equals final year's FCF

Answer: (A)

In a discounted cash flow, Enterprise Value is the present value of the firm’s expected free cash flows to the firm, discounted at the weighted average cost of capital. You forecast FCFF for each year, discount each year’s amount back to today using the WACC, and then sum them, including the terminal value that represents all cash flows after the explicit forecast period, discounted back as well. This total equals the Enterprise Value. Why the other ideas don’t fit: simply adding cash flows without discounting ignores the time value of money, so you’d overstate the value. The discounted tax shield represents a component used in alternative valuation approaches (like APV) or when focusing specifically on tax considerations, but not the overall EV in the standard DCF with FCFF. Taking only the final year’s FCF ignores all prior cash flows and the effects of discounting, so it doesn’t capture the full value of the firm.

In a discounted cash flow, Enterprise Value is the present value of the firm’s expected free cash flows to the firm, discounted at the weighted average cost of capital. You forecast FCFF for each year, discount each year’s amount back to today using the WACC, and then sum them, including the terminal value that represents all cash flows after the explicit forecast period, discounted back as well. This total equals the Enterprise Value.

Why the other ideas don’t fit: simply adding cash flows without discounting ignores the time value of money, so you’d overstate the value. The discounted tax shield represents a component used in alternative valuation approaches (like APV) or when focusing specifically on tax considerations, but not the overall EV in the standard DCF with FCFF. Taking only the final year’s FCF ignores all prior cash flows and the effects of discounting, so it doesn’t capture the full value of the firm.