Chartered Financial Analyst (CFA) Level 1 Practice Exam

In which scenario would interest expense be added back when calculating FCFF?

1. When it is subtracted from operating cash flow

2. When it is recorded as an operating expense

3. When converting net income to cash flow

4. When calculating the total liabilities

The correct answer is: When it is subtracted from operating cash flow

When calculating Free Cash Flow to the Firm (FCFF), interest expenses are typically treated differently from the operating profit calculations. In the context of FCFF, interest expenses are generally added back to net income because FCFF is intended to measure the cash available to all providers of capital, both debt and equity. This means that it needs to reflect the company's overall cash flow situation before considering interest payments that are a cost of financing rather than an operational cost. In the scenario where interest expense has been subtracted from operating cash flow, adding it back becomes necessary to accurately reflect the cash flow available to the firm itself rather than to its equity holders only. By adding back interest expense, one restores the cash flow figure to its full potential, effectively giving a clearer picture of the operating cash generation before financing costs are considered. This treatment aligns with the principle that FCFF should represent cash flows available to all capital providers. The other scenarios do not directly involve adjusting the cash flow measures used for FCFF calculation in a way that would necessitate adding back interest expense to reflect the firm's total cash flow accurately.