I have a question concerning the bleow exercise in schweser;

  1. 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!

So there might be a printing error here as FCFE = FCFF-interest(1-t)+net borrowings. You can surely say that FCFF is understated as he hasn’t added interest.

so answer b is supposed to the wright one!

No neither of them is correct. FCFF is understated and FCFE is overstated.

I would mark option C.

FCFF has been understated because he forgot to add-back the after-tax interests paid, clear and easy.

In the other hand, FCFE correct formula is FCFE = FCFF - int (1-t) + Net Borrowings, but he did just FCFF + Net Borrowings.

Since his erroneous calculation of FCFF is just FCFF = CFO - FCInv, then when his wrong FCFF is replaced into his (also) wrong FCFE formula, in coincidence he is actually calculating correctly the FCFE because the " - int (1-t) " adjustment is no longer required.

Please, feel free to correct me if I’m wrong.


His calculation of FCFF is understated by Int (1-t).

FCFE is CFO - FCInv + net borrow so he has actually calculated this correctly.

Therefore the correct answer is C.

oh very smart :smiley: