CFA Practice Question

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CFA Practice Question

Which of the following statements is (are) true with respect to valuing a company based on the cash flow that it generates?

I. Free cash flow to the firm (FCFF) is the cash that is available to both the equity holders and the debt holders of the firm.
II. FCFF is net of all operating expenses, but before deductions are made to maintain the operational efficiency of plant and equipment.
III. The withdraw of cash from the company, as estimated by FCFF, should not impede the growth of the company.
IV. Free cash flow to equity (FCFE) can never be greater than FCFF.
Correct Answer: I and III

II is incorrect because FCFF is net of all operating expenses and net of all deductions that are necessary to maintain the operational efficiency of the plant and equipment.

IV is incorrect because if the firm received more cash flow from the bondholders than the bondholders received from the firm, FCFE will actually be higher than FCFF. Always keep in mind, when you're dealing with cash flow, that the distinction between whether a payment to a bondholder is interest or principal repayment ceases to exist. So, technically, when bondholders put more money into a company, the cash to equity holders increases.

User Contributed Comments 9

User Comment
JVAC how FCFE can be > than FCFF??
mimi01 FCFE can be greater becos you are adding net borrowing to the figure.
HenryQ FCFE=FCFF-(Int(1-t)-NB), so if Int(1-t) <NB, FCFE is larger than FCFF. It all depends how much you borrow from bondholders vs how much interest you pay to them for a certain period.
kodali III is incorrect too if a firm withdraws all the FCFF then there is nothing to invest for growth. The capital investments made as part of FCFF is only to maintain the current capacity and not for growth.
chbourke No kodali. FCFF is the cash AFTER capital investment and WC investment. The company can still grow even if all FCFF is withdrewn.

FECF = NI - CAPEX - (Interest expense + Debt buyback)
rocyang Thanks Kokali! III got me, although in reality I (and many others) prefer those companies which are rich in cash reserve.
johntan1979 Yeah, thanks for making things clearer and clearer to me! You'll never learn much by reading and studying on your own.
quanttrader FCFE can be greater than FCFF since FCFE is cash available to shareholders net of cash paid to and recvd from bondholders. If cash recvd from bondholders > paid, then FCFE > FCFF
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