Chartered Financial Analyst (CFA) Level 1 Practice Exam

Which component is included in the calculation of Free Cash Flow to the Firm (FCFF)?

1. Interest expense × (1 - Tax rate)

2. Operating income - Capital expenditures

3. Cash from financing activities

4. Marketable securities + Deferred tax liabilities

The correct answer is: Interest expense × (1 - Tax rate)

Free Cash Flow to the Firm (FCFF) represents the cash generated by a company's operations that is available to all capital providers, including both equity and debt holders. It is calculated with the intent of assessing the financial health and valuation of a firm. In this context, the most relevant component for FCFF calculation is the adjustment for interest expense. Interest expense is typically excluded when calculating free cash flow, as it's considered a financing activity rather than an operational one. However, to properly reflect its effect on overall cash flows available to all capital providers, we adjust the interest expense by considering the tax shield it provides. The formula that reflects this is: FCFF = Operating Income (EBIT) × (1 - Tax Rate) + Depreciation - Capital Expenditures - Changes in Working Capital. The adjustment of interest expense multiplied by (1 - Tax rate) allows for capturing the net effect of financing costs while acknowledging the tax benefits that arise from interest expenses, making this component critically relevant to FCFF calculation. The other options are not properly aligned with how FCFF is determined. Operating income minus capital expenditures does not account for taxes or working capital changes, and cash from financing activities does not reflect operational cash generation. Lastly, adding marketable securities