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Financial Statement AnalysisAnalyzing Statements of Cash Flows II
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Question 1Exam level
Which of the following formulas correctly expresses FCFF starting from net income, most likely?
How sure are you?
Correct: A. FCFF = NI + NCC + Int(1-t) - FCInv - WCInv. Depreciation (a non-cash charge) is added back. After-tax interest is added back because FCFF represents cash available to ALL capital providers before any financing payments. FCInv (capital expenditure net of asset sales) and WCInv (increase in working capital) are subtracted as they represent cash outflows required to sustain operations.
B. The sign on the interest term is backwards here. FCFF measures cash available to every capital provider, lenders and shareholders alike, before any financing payments are made. Net income already has after-tax interest expense subtracted out, so that amount has to be added back, not subtracted again, to get from a shareholders-only number back to a whole-firm number.
C. FCInv is capital expenditure net of asset sales, a cash outflow the firm must make to sustain and grow operations, so it is subtracted from net income, not added. Adding it back would overstate the cash actually available to all the firm's capital providers.
Unit: analyzing-statements-of-cash-flows-ii
Question 2Exam level
A firm has net income of $200M, depreciation of $40M, capital expenditure of $60M, an increase in working capital of $15M, and interest expense of $30M. The tax rate is 30%. The FCFF is closest to:
How sure are you?
Correct: B. FCFF = NI + Dep + Int(1-t) - FCInv - WCInv = 200 + 40 + 30(1-0.30) - 60 - 15 = 200 + 40 + 21 - 60 - 15 = $186M. The key step is computing after-tax interest: 30 × 0.70 = $21M and adding it back. Candidates who forget to add back after-tax interest get $165M (option B).
A. You might have calculated the answer by adding back the full interest expense without adjusting for taxes, leading to $165M, but this approach overlooks the need to add back only the after-tax interest expense, which is $21M, not the full $30M.
C. Choosing $195M might tempt you if you mistakenly add back the full interest expense of $30M instead of the after-tax interest of $21M, violating the rule that only after-tax interest is added back to net income to calculate FCFF.
Unit: analyzing-statements-of-cash-flows-ii
Question 3Exam level
Using the data from Question 2, if net borrowing for the year is $10M, FCFE is closest to:
How sure are you?
Correct: B. FCFE = FCFF - Int(1-t) + Net Borrowing = 186 - 21 + 10 = $175M. Alternatively: FCFE = NI + Dep - FCInv - WCInv + Net Borrowing = 200 + 40 - 60 - 15 + 10 = $175M. Both approaches give the same result. Net borrowing is ADDED because new debt issuance provides cash to equity holders. Candidates who subtract net borrowing get $155M (option A).
A. You might be tempted to choose $165M if you mistakenly subtracted the interest tax shield from the FCFF, leading to an incorrect FCFE calculation; remember, the interest tax shield should be subtracted from FCFF before adding net borrowing to arrive at FCFE.
C. You might be tempted to choose $196M if you mistakenly add the interest tax shield to the FCFE calculation, but FCFE already accounts for the after-tax interest expense, so adding the tax shield again inflates the figure incorrectly.
Unit: analyzing-statements-of-cash-flows-ii
Question 4Exam level
An analyst is valuing a company using a single-stage free cash flow model. The firm has FCFF of $50M, WACC of 9%, and a long-term growth rate of 4%. The value of the firm (enterprise value) is closest to:
How sure are you?
Correct: B. FCFF Firm Value = FCFF1 / (WACC - g). FCFF1 = FCFF0 × (1+g) = 50 × 1.04 = $52M. Firm Value = 52 / (0.09 - 0.04) = 52 / 0.05 = $1,040M. The closest answer is C ($1,000M), which assumes FCFF1 is already given as the next period value (i.e., FCFF1 = $50M already). If FCFF is given as next year's value: 50 / (0.09 - 0.04) = $1,000M. This is the standard exam presentation where FCFF1 is given directly. Candidates who divide by WACC alone (50/0.09) get $556M (option B).
A. Choosing $556M might seem correct if you mistakenly divide the FCFF by the WACC alone, but this ignores the growth rate, leading to an incorrect valuation; the correct approach requires using the formula FCFF1 / (WACC - g) to account for long-term growth.
C. Choosing $1,250M might tempt you if you mistakenly add the growth rate to the WACC instead of subtracting it, leading to an incorrect denominator of 0.13, but the formula requires subtracting the growth rate from WACC to properly discount future cash flows, resulting in the correct denominator of 0.05.
Unit: analyzing-statements-of-cash-flows-ii
Question 5Exam level
Which discount rate is appropriate for discounting FCFF to find firm value, and which is most likely appropriate for discounting FCFE to find equity value?
How sure are you?
Correct: A. FCFF is cash available to all capital providers (debt and equity). It must be discounted at WACC, the blended required return of all capital providers, to arrive at total firm (enterprise) value. FCFE is cash available only to equity holders and must be discounted at ke (required return on equity) to arrive at equity value. This is the most-tested conceptual distinction in the entire FCF valuation reading. Option A is the most common wrong answer. Candidates confuse which cash flow belongs to whom.
B. You might think that using WACC for both FCFF and FCFE is consistent, but this overlooks the fundamental difference that FCFE is cash flow specifically available to equity holders, which should be discounted at the required return on equity (ke), not WACC.
C. You might be tempted to choose the risk-free rate for FCFF because it seems safer, but this violates the principle that FCFF should be discounted at WACC, which reflects the average cost of all sources of capital, not just the risk-free rate.
Unit: analyzing-statements-of-cash-flows-ii
Question 6Harder
A firm's WACC is 10% and its required return on equity (ke) is 13%. FCFF is $80M and FCFE is $55M. If an analyst uses ke to discount FCFF, the resulting firm value will most likely be:
How sure are you?
Correct: A. Using ke (13%) instead of WACC (10%) to discount FCFF produces a lower present value because the denominator (ke - g) is larger. The resulting firm value is UNDERSTATED. The correct discount rate for FCFF is WACC. Since ke > WACC (equity is riskier than the firm's blended capital), using ke applies too high a discount rate to firm-level cash flows, reducing the computed value below its true level. Options A and B both state the correct direction of error. B is more precise in stating the value is understated.
B. Choosing B might tempt you because ke does indeed reflect systematic risk, but this overlooks the fact that FCFF should be discounted at WACC, which represents the firm's overall cost of capital, not just the equity component.
C. Choosing C might tempt you because it restates the relationship between WACC and ke, but it fails to recognize that using ke to discount FCFF overstates the risk, leading to an understated firm value, contrary to the proper application of WACC for FCFF valuation.
Unit: analyzing-statements-of-cash-flows-ii
Question 7Harder
FCFF can also be calculated starting from cash flow from operations (CFO). Which formula is most likely correct?
How sure are you?
Correct: A. FCFF = CFO + Int(1-t) - FCInv. CFO (under GAAP) already deducts after-tax interest paid (interest expense is included in operating activities under US GAAP). To get FCFF, we must ADD BACK Int(1-t) to remove the financing payment and arrive at pre-financing free cash flow. Then subtract FCInv (capital expenditure net of asset sales) because CFO does not include investing outflows. This distinction is testable.
B. CFO under GAAP already has after-tax interest paid built in as an operating cash outflow, so subtracting Int(1-t) again double counts that financing payment. To convert CFO into FCFF, the cash available to every capital provider before financing costs, the after-tax interest has to be added back, not subtracted a second time, before FCInv is removed for capital spending.
C. Choosing C might seem logical if you assume FCFF is simply CFO adjusted for capital expenditures, but this overlooks the need to add back the tax shield from interest payments, which is crucial for accurately reflecting the cash flow available to all investors after accounting for operating and investing activities.
Unit: analyzing-statements-of-cash-flows-ii
Question 8Exam level
A company has FCFF of $100M, debt of $400M, and WACC of 8% with a long-term growth rate of 3%. The value of equity is closest to: (Assume FCFF1 = $100M)
How sure are you?
Correct: A. Step 1: Firm Value = FCFF1 / (WACC - g) = 100 / (0.08 - 0.03) = 100 / 0.05 = $2,000M. Step 2: Equity Value = Firm Value - Debt = 2,000 - 400 = $1,600M. This two-step process is the standard exam approach: compute firm value from FCFF, then subtract debt to get equity value. Option B is the trap. Candidates stop at Step 1 and forget to subtract debt. This is the single most common error in FCFF-to-equity-value questions.
B. Option B is the trap. You might stop at Step 1 and forget to subtract debt.
C. Choosing $2,400M might tempt you if you mistakenly added the debt to the firm value instead of subtracting it, confusing the relationship between firm value and equity value, where equity is calculated by subtracting debt from the total firm value.
Unit: analyzing-statements-of-cash-flows-ii
Question 9Exam level
Which of the following situations is most likely to cause an analyst to prefer FCFF over FCFE for valuation?
How sure are you?
Correct: A. When capital structure is changing, FCFE becomes unstable and difficult to forecast because FCFE depends on net borrowing, which fluctuates with leverage changes. FCFF avoids this problem by measuring pre-financing cash flows. The firm's value can be computed from FCFF using WACC, which remains more stable during capital structure changes (though WACC also shifts with leverage, this is a second-order effect). The CFA curriculum explicitly states: use FCFF when capital structure is expected to change significantly. Options A and D suggest stability. DDM or FCFE would work fine there. Option C (no debt) means FCFF = FCFE, so either works.
B. You might think that consistent free cash flow makes FCFE more reliable, but since the firm has no debt, FCFF and FCFE are identical, making the choice between them irrelevant; the key issue is the changing capital structure, which makes FCFF preferable as it is unaffected by leverage changes.
C. You might be tempted by choice C because it suggests stability in dividend payments, which could imply predictability in FCFE. However, FCFF is preferred when capital structure changes significantly, not when dividends are stable; choice C actually indicates a scenario where FCFE would be reliable and thus does not necessitate the use of FCFF.
Unit: analyzing-statements-of-cash-flows-ii
Question 10Exam level
A firm reports the following for the year: Net Income = $300M, Depreciation = $50M, Capital Expenditure = $80M, Increase in Working Capital = $20M, Interest Expense = $40M, Tax Rate = 25%, Net Borrowing = -$15M (net debt repayment). The FCFE is closest to:
How sure are you?
Correct: A. FCFE = NI + Dep - FCInv - WCInv + Net Borrowing = 300 + 50 - 80 - 20 + (-15) = $235M. Net borrowing is negative because the firm repaid debt, which is a cash OUTFLOW to equity holders. FCFF = NI + Dep + Int(1-t) - FCInv - WCInv = 300 + 50 + 40(0.75) - 80 - 20 = 300 + 50 + 30 - 80 - 20 = $280M. Cross-check: FCFE = FCFF - Int(1-t) + Net Borrowing = 280 - 30 + (-15) = $235M. Both methods confirm $235M. Option B ($220M) is the trap for candidates who subtract net borrowing as an absolute value rather than applying the correct sign.
B. Option B ($220M) is the trap for candidates who subtract net borrowing as an absolute value rather than applying the correct sign.
C. Choosing $265M might tempt you if you mistakenly add the net borrowing as a positive value, thinking it represents cash inflow, but net borrowing is negative here, indicating a cash outflow, thus you should subtract $15M instead of adding it.
Unit: analyzing-statements-of-cash-flows-ii
Question 11Exam level
Under the single-stage FCFE model, an analyst estimates next year's FCFE at $4 per share, the required return on equity at 11%, and the long-term growth rate at 5%. The intrinsic value per share is closest to:
How sure are you?
Correct: A. V0 = FCFE1 / (ke - g) = 4 / (0.11 - 0.05) = 4 / 0.06 = $66.67. This is the Gordon Growth Model applied to FCFE instead of dividends. The structure is identical to the DDM. The only difference is that FCFE replaces dividends as the numerator. Option A ($36.36) is the trap for using ke in the denominator without subtracting g: 4/0.11. Option C ($57.14) uses the wrong spread: 4/0.07. This question tests whether candidates recognize the FCF perpetuity formula.
B. You might be tempted by choice B if you incorrectly used a growth rate of 6% instead of the correct 5%, leading to a denominator of 0.05, which violates the proper application of the FCFE model where the growth rate is subtracted from the required return on equity.
C. Choosing $44.44 might tempt you if you mistakenly used a growth rate of 4% instead of 5%, leading you to calculate 4 / (0.11 - 0.04) = $57.14, but then incorrectly adjusted for a different figure, showing a miscalculation in applying the growth rate within the formula.
Unit: analyzing-statements-of-cash-flows-ii
Question 12Harder
Under US GAAP, how is interest paid classified in the cash flow statement, and what adjustment is most likely required when calculating FCFF from CFO?
How sure are you?
Correct: A. Under US GAAP, interest paid is classified as an OPERATING activity. This means CFO already reflects the after-tax cost of interest paid. To compute FCFF (pre-financing cash flow available to all providers), you must ADD BACK after-tax interest Int(1-t) to remove the financing effect embedded in CFO. Under IFRS, interest paid may be classified as financing, in which case no add-back is required. This GAAP vs IFRS distinction is directly tested in the CFA curriculum. Option C (gross interest) is wrong. You add back the after-tax amount, not the gross amount.
B. Option C (gross interest) is wrong. You add back the after-tax amount, not the gross amount.
C. Option C (gross interest) is wrong. You add back the after-tax amount, not the gross amount.
Unit: analyzing-statements-of-cash-flows-ii
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