I have a question concerning the bleow exercise in schweser;
- Suppose an analyst uses the statement of cash flows to calculate free cash flow to the firm (FCFF) as cash flow from operations less fixed capital investment, and free cash flow to equity (FCFE) as FCFF plus net borrowing. The firm has short- and long-term debt on its balance sheet. Has the analyst correctly stated, overstated, or understated FCFF and FCFE? FCFF; FCFE A. Overstated; Correct B. Understated; Understated C. Understated; Correct The firm must have interest expense on its income statement because of the debt on its balance sheet. By ignoring the after-tax interest cash flow, the analyst has understated FCFF, which is actually equal to CFO plus after-tax interest cash flow less fixed capital investment. He has, however, calculated FCFE correctly because FCFE is equal to CFO less fixed capital investment (his incorrect FCFF calculation) plus net borrowing.
Since FCFF is primarily incorrect, hence relying on it to calculate FCFE will definetly underestimate FFCE as well!