Chartered Financial Analyst (CFA) Level 1 Practice Exam

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

1. Cash flow from operating activities - Investment in fixed capital + Net borrowing

2. Net income - Depreciation + Amortization - Capital expenditures

3. Operating cash flow - Changes in working capital - Dividends

4. Cash flow from investments - Cash flow from financing

The correct answer is: Cash flow from operating activities - Investment in fixed capital + Net borrowing

Free Cash Flow to Equity (FCFE) is a measure of how much cash available after accounting for necessary expenditures is available to equity shareholders. The formula is designed to show the cash flows that can be distributed to equity holders after all operational costs, capital expenditures, and any profit retained for investment are fulfilled. The correct formula, which is outlined as cash flow from operating activities minus investment in fixed capital plus net borrowing, highlights the core components essential for calculating FCFE. - Cash flow from operating activities represents the cash generated from the company's core business operations, which is crucial since it reflects the primary source of cash inflow. - Investment in fixed capital accounts for expenditures that are necessary to maintain or expand the asset base; thus, it's subtracted from cash flows to show the cash used up for such investments. - Net borrowing adds any funds acquired through new debts because this financing provides additional liquidity that can be used for equity distribution. This comprehensive approach ensures that the cash flows available to equity holders are presented accurately, as it factors in operational performance, necessary investments, and the effect of external financing. Because of these components, the first option represents the appropriate framework for determining FCFE.