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Why is the rate used to discount FCFF different from the rate used to discount FCFE?

Why is the rate used to discount FCFF different from the rate used to discount FCFE?

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Answer #1

Rate which is used to discount free cash flows to the firm will be different to rate which isused to discount free cash flow to equity because free cash flow to firm will be representing the free cash flow which is available to the debt holder as well as preferred shareholder as well as equity shareholders, so there would be a cumulative cost of capital that should be used to discount the free cash flow which is available to the firm.

free cash flow to the equity will be representing the portion of ownership of equity share holder and hence we will be using cost of equity in order to discount free cash flows to the equity so there is a a difference in both the approaches of valuation while selection of discounting rate due to their nature of used by different stakeholders.

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