Chartered Financial Analyst (CFA) Practice Exam Level 2

Which of the following is NOT a method for calculating Free Cash Flow to the Firm (FCFF)?

1. FCFF = NI + Dep - FCINV - WCINV

2. FCFF = (EBIT) * (1 - t) + (Dep) - (FC INVEST) - (WC INV)

3. FCFF = CFO + (Net Borrowing) + (Interest Expense)

4. FCFF = EBITDA * (1 - t) - (FCINV)

The correct answer is: FCFF = CFO + (Net Borrowing) + (Interest Expense)

The correct choice is identified as a method that does not accurately calculate Free Cash Flow to the Firm (FCFF). FCFF is a measure of a company's profitability that accounts for cash flows available to all shareholders, including equity and debt investors. The appropriate methods for calculating FCFF are derived from the net income or operating income and adjust for non-cash items and changes in working capital, as well as capital expenditures. The method involving CFO (Cash Flow from Operations), net borrowing, and interest expense includes net financing activities, which is not part of the FCFF calculation. FCFF focuses solely on operating performance and the cash generated by the firm before financing costs. The direct connection to changes in working capital and capital investment is essential to determine the actual liquidity available to all capital providers. In contrast, the other methods incorporate relevant adjustments for calculating FCFF by properly incorporating net income or EBIT, tax impacts, and necessary capital expenditures to reflect operational cash flow effectively. Using net borrowing and interest expense deviates from this focus, hence confirming that this method is not suitable for calculating FCFF.