Chartered Financial Analyst (CFA) Level 1 Practice Exam

Which of the following does NOT factor into the calculation of FCFF?

1. Interest expense adjusted for tax

2. Cash flow from operating activities

3. Dividends paid

4. Investment in fixed capital

The correct answer is: Dividends paid

Free Cash Flow to the Firm (FCFF) is a measure of a company's profitability that considers cash flows generated by its operations, adjusted for its capital expenditures and working capital needs, but does not account for financing activities. Dividends paid are not included in the calculation of FCFF because they are distribution to shareholders and represent cash that has already been committed from the firm's cash flows. FCFF focuses on the cash that is available to all investors – both debt and equity holders – and intends to reflect the operational cash flows of the company before any payments to shareholders are made. On the other hand, factors like interest expense adjusted for tax, cash flow from operating activities, and investment in fixed capital are integral to calculating FCFF. Interest expense is adjusted for tax because FCFF is calculated on an after-tax basis to reflect the cash available to all providers of capital. Cash flow from operating activities is a starting point in the FCFF calculation, and investments in fixed capital are necessary to maintain and grow the company’s operational capabilities and thus impact the cash flow available to investors. Understanding these components helps clarify why dividends paid do not factor into FCFF calculations, as they are not relevant to the cash available for future investment and operating activities.