Chartered Financial Analyst (CFA) Practice Exam Level 2

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How is Free Cash Flow to the Firm (FCFF) calculated?

FCFF = (Gross Rental Income) - (Interest Expense)
FCFF = (Net Income) + (Interest Expense) * (1 - t) - (FCINV)
FCFF = (EBITDA) * (1 - t) - (FCINV) - (WC INV)
FCFF = CFO + (IntExp) + (Net Borrowing)

The correct answer is: FCFF = (Net Income) + (Interest Expense) * (1 - t) - (FCINV)

Free Cash Flow to the Firm (FCFF) represents the cash generated by a company's operations, available to all investors, before any payments to debt holders or equity holders. The correct calculation method involves starting with the net income, adjusting for the fact that interest is a financing cost, and not part of operating profit. This is why we add back the interest expense multiplied by (1 - tax rate); this effectively converts net income into an operating measure, removing the impact of financing decisions. Then, subtracting capital expenditures (denoted as FCINV) reflects the cash needed to maintain or expand the asset base required for operations, and provides insight into the actual cash available for the firm's stakeholders. Essentially, this calculation provides a clearer view of the firm's operating performance and its ability to generate cash flow, irrespective of its capital structure. The other choices provide incorrect perspectives on determining FCFF, such as including gross rental income without proper adjustments for expenses or misrepresenting the relationship between cash flow and operational expenses in the context of financing.