McKinsey's Part Two begins with a critical observation: there are four distinct DCF-based approaches to valuation, and they produce identical answers when applied correctly. Understanding why they are equivalent — and when each is the right tool — is the foundation of professional DCF practice. Most errors in advanced valuation come from mixing components of one framework with another.
Every DCF model answers the same question: what is the present value of future cash flows? But 'future cash flows' has four legitimate definitions — each of which belongs to a different set of investors and must be discounted at the rate appropriate to those investors. Mixing the wrong cash flow with the wrong discount rate is the single most common technical error in applied valuation, and the error is multiplicative: the longer the projection period, the larger the divergence.
| Framework | Cash Flow Discounted | Discount Rate | Output | Best Used When |
|---|---|---|---|---|
| Entity DCF (FCFF) | Free Cash Flow to Firm — cash available to ALL investors (equity + debt) before financing | WACC — weighted average of cost of equity and after-tax cost of debt | Enterprise Value → subtract Net Debt → Equity Value | Standard case; target has a stable, well-defined capital structure |
| Equity DCF (FCFE) | Free Cash Flow to Equity — cash available to EQUITY holders after debt service | Cost of Equity (Ke) from CAPM | Equity Value directly — no bridge from EV needed | Financial institutions (banks, insurance) where debt is an operating input; also useful for highly leveraged structures |
| Adjusted Present Value (APV) | Unlevered free cash flow (as if all-equity) + separately valued debt tax shields | Unlevered cost of equity (Ku) for the operating cash flows; risk-free rate for near-certain tax shields | Enterprise Value = Unlevered + Tax Shield PV → subtract Debt → Equity Value | Complex or changing capital structures; LBO analysis; project finance where debt follows a structured repayment schedule |
| Economic Profit (EP) | Economic Profit = NOPAT − (WACC × Invested Capital); the residual value created above cost of capital | WACC | Enterprise Value = Invested Capital + PV of all future Economic Profits | Performance measurement; explaining the gap between book value and market value; internal capital allocation |
The equivalence of all four models is not a coincidence — it is a mathematical identity. Each model is a different algebraic rearrangement of the same underlying cash flow reality. McKinsey devotes significant attention to this proof because practitioners who understand it make fewer errors and can diagnose discrepancies between models faster.
Entity DCF: EV = PV(FCFF at WACC). Equity DCF: Equity Value = PV(FCFE at Ke). The bridge: FCFE = FCFF − After-tax Interest + Net Debt Issuance. If the balance sheet assumptions are consistent (the same debt schedule is embedded in both), discounting FCFE at Ke and discounting FCFF at WACC must produce the same equity value. The discount rates differ to reflect the leverage embedded in each cash flow — FCFF is pre-leverage and so WACC is higher than Ke-unleveraged; FCFE is post-leverage and Ke reflects the financial risk of the remaining equity claim.
The entity DCF is the standard approach in investment banking, equity research, and management consulting because FCFF is capital-structure neutral — you can calculate it without a debt schedule and reconcile it to any capital structure. McKinsey's standard model structure has four components:
| Component | Projection Period | What to Forecast | Critical Assumption |
|---|---|---|---|
| Phase 1: Explicit Forecast | Years 1–5 (or 1–10 for long-cycle businesses) | Revenue growth, EBIT margin, tax rate, D&A, capex, working capital changes → FCFF each year | All assumptions must be internally consistent with the reinvestment rate implied by g/ROIC |
| Phase 2: Fade Period | Years 6–10 (optional; used when Phase 1 is 5 years) | Gradual convergence of high returns and growth toward long-run sustainable levels; allows the terminal value to be less sensitive to extreme assumptions | ROIC should fade toward cost of capital unless a structural moat prevents this |
| Terminal Value | Year T+1 to infinity (Gordon Growth Model or Exit Multiple) | Perpetuity growing at the long-run nominal GDP growth rate; terminal ROIC must be defensible | Terminal year assumptions must be self-consistent: reinvestment rate = g_terminal / ROIC_terminal; FCF_terminal = NOPAT × (1 − g/ROIC) |
| Enterprise → Equity Bridge | Balance sheet at valuation date | Subtract: Net Debt (Debt − Cash), Minority Interest, Unfunded Pension; Add: Value of non-operating assets, investments in associates | Use market values where available; book values for debt (if close to par); excess cash only, not operating cash |
Entity DCF — Core Formula
EV = Σ [FCFF_t / (1+WACC)^t] + [TV / (1+WACC)^T]
Where TV = FCFF_{T+1} / (WACC − g) using the Gordon Growth Model, and FCFF_{T+1} = NOPAT_{T+1} × (1 − g/ROIC)
APV and the Economic Profit model are not alternative preferences — they solve specific problems that the standard entity DCF cannot handle well. Choosing the right framework based on the valuation problem is a mark of professional practice.
| Framework | Problem It Solves | Situation It Fits | Example Application |
|---|---|---|---|
| APV | WACC assumes constant leverage ratio; when debt repayments are known in advance, the tax shield has a different risk profile than operating cash flows | LBOs (aggressive debt repayment schedule); project finance (structured debt); highly leveraged acquisitions | An LBO model with a 7-year debt paydown schedule: each year's tax shield is near-certain once the debt is in place; APV discounts shields at Rf, operating FCF at Ku, then sums |
| APV | Cross-border valuations where subsidized debt (government loan guarantees, development bank financing) creates tax shields with different risk | Infrastructure projects, public-private partnerships, sovereign-adjacent financing | A toll road project with 30-year government-guaranteed bonds at below-market rates — the interest deduction value is certain; embed it separately in APV |
| Economic Profit | Bridging market value to book value for performance measurement and internal capital allocation decisions | Conglomerates allocating capital across divisions; management compensation tied to value creation metrics | A multi-division company evaluating whether each division earns above its cost of capital — EP makes this explicit and avoids accounting distortions from growth investing |
| Economic Profit | Explaining why a business with good ROE but low ROIC appears to trade at or below book value | Businesses where accounting ROE overstates ROIC due to leverage or off-balance-sheet intangibles | A retailer with high financial leverage — ROE looks healthy but ROIC is low; EP shows the business destroys value despite positive net income |
For most valuations, the entity DCF using FCFF and WACC is the correct framework. Use APV for LBOs and structured-debt situations where the debt schedule is explicit and changes significantly over time. Use the Economic Profit model as a supplement to entity DCF for performance measurement and to explain the relationship between book value and market value. Never use multiple frameworks in the same model without reconciling them to confirm they produce the same answer.
Key Takeaways
A company has FCFF of $50M per year (flat forever), WACC of 10%, and Net Debt of $200M. What is the equity value? Now suppose you use the Equity DCF framework instead. The company has $20M in after-tax interest expense and no debt issuance. What is FCFE, and what discount rate must you use to arrive at the same equity value?