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ACCA Strategic Professional · Advanced Financial Management · Valuation and the use of free cash flows

Which of the following is the correct starting point and adjustment when deriving Free Cash Flow to Firm (FCFF) from a company's operating profit?

FCFF starts from EBIT, deducts tax calculated on EBIT, adds back depreciation and subtracts net capital investment and working capital increases. It is measured before any financing flows, so interest, dividends and net borrowing are excluded, because it represents cash available to all capital providers.

  1. AStart with EBIT, deduct tax on EBIT, add back depreciation, deduct net capital investment and increase in working capitalCorrect
  2. BStart with profit after interest and tax, add back depreciation, deduct net capital investment and deduct interest paid
  3. CStart with EBIT, deduct tax actually paid after the interest tax shield, add back depreciation and deduct dividends paid
  4. DStart with profit after tax, add back depreciation and add net new borrowing

Explanation

FCFF is the cash flow available to all capital providers before financing flows. It is EBIT less tax on EBIT, plus non-cash charges such as depreciation, less investment in non-current assets and working capital. Option B deducts interest, which makes it closer to an equity measure, and option D adds net borrowing, which is a financing flow.

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