25400 · Financial Literacy
Investment Strategies & Portfolio Management
Week 9 contrasts active and passive investing, applies the risk-return trade-off and diversification to portfolio construction, and introduces income-based valuation through free cash flow (FCFF vs FCFE). FCFF is the cash available to all capital providers (discounted at WACC); FCFE is the cash available to equity (discounted at the cost of equity). This valuation engine drives the group Excel financial model — Assessment 2 — due this week, tying the scenario analysis of Week 8 back to a company valuation.
What this chapter covers
- 01Active vs passive investing: seeking to beat the market (higher cost) vs tracking an index (lower cost)
- 02Risk-return trade-off: higher expected return requires accepting higher risk
- 03Diversification: combining imperfectly-correlated assets cuts unsystematic risk without proportionally cutting return
- 04Portfolio expected return E(Rp) = Σ w_i · E(R_i) (weighted average of asset returns)
- 05Systematic risk and CAPM: E(Ri) = Rf + βi(Rm − Rf); beta measures market sensitivity
- 06Free cash flow: FCF = Operating Cash Flow − CapEx; FCF vs net income and quality of earnings
- 07FCFF = EBIT(1 − Tc) + Depreciation − CapEx − ΔNWC (all capital providers; discount at WACC)
- 08FCFE (equity holders; discount at cost of equity) and its role in the group financial model
Computing free cash flow to the firm (FCFF)
- +1Start with after-tax operating profit: EBIT(1 − Tc) = 200 × (1 − 0.30) = 200 × 0.70 = $140m. This is the operating profit left after tax but before financing.
- +1Add back depreciation, a non-cash expense: 140 + 40 = $180m.
- +1Subtract the cash reinvested in the business — capital expenditure and the increase in net working capital: 180 − 70 − 15 = $95m.
- +1FCFF = EBIT(1 − Tc) + Depreciation − CapEx − ΔNWC = 140 + 40 − 70 − 15 = $95m. Because FCFF is cash available to all capital providers (debt and equity), it is discounted at the WACC to value the whole firm.
Key terms
- Active vs passive investing
- Active strategies try to beat the market through security selection and timing, incurring higher costs; passive strategies simply track an index at low cost. The choice trades the hope of outperformance against fees and effort.
- Diversification
- Combining assets whose returns are not perfectly correlated so that some fluctuations offset, reducing a portfolio's unsystematic (firm-specific) risk without proportionally reducing its expected return.
- Portfolio expected return
- The weighted average of the expected returns of the assets held, E(Rp) = Σ w_i · E(R_i), where the weights are the portfolio proportions invested in each asset.
- Free cash flow (FCF)
- The cash a business generates after operating expenses and the capital expenditure needed to maintain its asset base, FCF = Operating Cash Flow − CapEx. It is harder to manipulate than net income and signals earnings quality.
- FCFF
- Free Cash Flow to the Firm: cash available to all capital providers, FCFF = EBIT(1 − Tc) + Depreciation − CapEx − ΔNWC. It is discounted at the WACC to value the entire firm.
- FCFE
- Free Cash Flow to Equity: cash available to shareholders after debt payments. It is discounted at the cost of equity to value the equity directly, in contrast to FCFF's whole-firm view.
Investment Strategies & Portfolio Management FAQ
What is the difference between FCFF and FCFE?
FCFF is the cash available to all capital providers (debt and equity) before financing flows, and it is discounted at the WACC to value the whole firm. FCFE is the cash left for equity holders after interest and net debt movements, and it is discounted at the cost of equity to value equity directly. Matching each cash flow to the right discount rate is essential.
Why is free cash flow preferred to net income for valuation?
Net income includes non-cash items (like depreciation) and is more open to accounting choices, whereas free cash flow measures actual cash generated after reinvestment. Two firms with identical net income can have very different free cash flow, and the higher-FCF firm has more real flexibility to pay dividends, invest or repay debt.
How does diversification reduce risk without killing return?
Because assets do not move perfectly together, gains in some offset losses in others, smoothing the portfolio and cutting firm-specific (unsystematic) risk. Expected return is just the weighted average of the components, so combining imperfectly-correlated assets lowers volatility more than it lowers expected return.
Why does this week matter for the assessment?
The group Excel financial model (Assessment 2) is due in Week 9, and free-cash-flow valuation is its engine — you forecast FCFF or FCFE and discount it, running the scenario analysis from Week 8 through to a company value. Getting the FCF definitions and their discount rates right here is directly assessed there.
Assessment move
Separate the two threads of this week and connect them: the portfolio side (active vs passive, risk-return, diversification, and the weighted-average expected return) and the valuation side (free cash flow). For valuation, drill the FCFF build — after-tax EBIT, add back depreciation, subtract CapEx and the change in net working capital — and always pair FCFF with the WACC and FCFE with the cost of equity. Because Assessment 2 (the group financial model) is due now, rehearse the FCF forecast and discounting in a spreadsheet and link it to the Week-8 scenario analysis. Ask Sia to set fresh FCFF/FCFE and portfolio-return problems and check your discount-rate pairing.
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