An analyst is calculating Free Cash Flow to the Firm (FCFF). Which of the following adjustments to Net Income is CORRECT?

Answer options:

Add Interest Expense (tax-effected) and subtract Dividends.

Add Depreciation, subtract Capital Expenditures, subtract Increase in Working Capital, subtract Interest Expense.

Add Depreciation, add Interest Expense (1 - Tax Rate), subtract Capital Expenditures, subtract Increase in Working Capital.

Add Depreciation, subtract Capital Expenditures, add Net Borrowing.

How to approach this question

FCFF is cash flow available to ALL providers of capital (Debt + Equity). Start with Net Income, add back non-cash (Depr), add back interest (since it was subtracted to get NI, but belongs to debt holders), subtract investments (Capex, WC).

Full Answer

C.Add Depreciation, add Interest Expense (1 - Tax Rate), subtract Capital Expenditures, subtract Increase in Working Capital.✓ Correct

FCFF starts with Net Income. We add back Interest Expense * (1-Tax Rate) because interest is a return to debt holders (part of the 'Firm'). We add Depreciation (non-cash). We subtract investments in fixed assets (Capex) and Working Capital.

Common mistakes

Confusing FCFF with FCFE (which includes net borrowing); forgetting to tax-effect the interest add-back.

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