Chartered Financial Analyst (CFA) Practice Exam Level 2

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Prepare for the CFA Exam Level 2 with flashcards and multiple-choice questions. Each question includes hints and explanations to boost your confidence and enhance your study process. Get ready for success!

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Which formula correctly calculates Free Cash Flow to Equity (FCFE)?

FCFE = NI + Depreciation - FC INV - WC INV
FCFE = (FCFF) - (IntExp) * (1 - t) + (Net Borrowing)
FCFE = EBIT * (1 - t) + (Dep) - (FC INV) - (WC INV)
FCFE = (NI) + (Depreciation) + (IntExp) - (FCINV)

The correct answer is: FCFE = (FCFF) - (IntExp) * (1 - t) + (Net Borrowing)

Free Cash Flow to Equity (FCFE) represents the cash available to equity shareholders after all expenses, reinvestments, and debt payments have been made. The correct formula for calculating FCFE takes into account the cash generating ability of the firm and the effects of capital structure decisions. Option B provides the correct calculation by starting with Free Cash Flow to the Firm (FCFF), which represents the cash generated before considering debt payments. It then adjusts for interest expenses, taking into account the tax shield on interest (since interest is tax-deductible). Net borrowing is added because it reflects the cash inflow from new debt taken during the period, which impacts the equity holders. This method accurately captures the cash available specifically for equity shareholders, as it reflects both the firm's operating performance and the financing choices made. This approach is essential in understanding how much cash is ultimately available for distribution to equity holders after considering all relevant financial activities, which aligns with the overall goal of FCFE assessment.