LOS d: Discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE.

Q1. The following information is derived from the financial records of Brown Company for the year ended December 31, 2004:

• Brown issued bonds on June 30, 2004 and received proceeds of $4,000,000.
• Old equipment with a book value of $2,000,000 was sold on August 15, 2004 for $2,400,000 cash.
• Brown purchased land for a new factory on September 30, 2004 for $3,000,000, issuing a $2,000,000 note and paying the balance in cash.

Using the definition of free cash flow to equity (FCFE) as cash flow from operations less capital expenditures, Brown’s free cash flow (FCF) available to equity shareholders for 2004 is:

A)   $2,200,000.

B)   $200,000.

C)   $6,200,000.

Q2. Free cash flow to the firm (FCFF) adjusts earnings before interest and taxes (EBIT) by:

A)   deducting taxes, adding back depreciation, and deducting the investments in fixed capital and working capital.

B)   subtracting investments in fixed capital and working capital.

C)   adding taxes, deducting depreciation, and adding back the investments in fixed capital and working capital.

Q3. In computing free cash flow, the most significant non-cash expense is usually:

A)   deferred taxes.

B)   depreciation.

C)   capital expenditures.

Q4. Which of the following items is NOT subtracted from the net income to calculate free cash flow to equity (FCFE)?

A)   Subtractions to notes payable.

B)   Additions to cash.

C)   Interest payments to bondholders.

LOS d: Discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE. fficeffice" />

Q1. The following information is derived from the financial records of Brown Company for the year ended December 31, 2004:

Sales	$3,400,000
Cost of Goods Sold (COGS)	(2,100,000)
Depreciation	(300,000)
Interest Paid	(200,000)
Gain on ffice:smarttags" />Sale of Old Equipment	400,000
Income Taxes Paid	(300,000)
Net Income	$900,000

• Brown issued bonds on June 30, 2004 and received proceeds of $4,000,000.
• Old equipment with a book value of $2,000,000 was sold on August 15, 2004 for $2,400,000 cash.
• Brown purchased land for a new factory on September 30, 2004 for $3,000,000, issuing a $2,000,000 note and paying the balance in cash.

Using the definition of free cash flow to equity (FCFE) as cash flow from operations less capital expenditures, Brown’s free cash flow (FCF) available to equity shareholders for 2004 is:

A)   $2,200,000.

B)   $200,000.

C)   $6,200,000.

Correct answer is A)

Brown’s cash flow from operations (CFO) was $800,000 = ($900,000 Net Income + $300,000 depreciation ? $400,000 gain).
Capital expenditure cash flows were ?$1,000,000 for the factory and $2,400,000 cash received from sale of the old equipment for a net inflow of cash of $1,400,000.
FCF available to shareholders was $2,200,000 = ($800,000 + $1,400,000).
Note that in the case of the factory, the $2,000,000 that was financed using a mortgage note would not be part of the statement of cash flows (SCF), but would be included in the SCF notes.

Q2. Free cash flow to the firm (FCFF) adjusts earnings before interest and taxes (EBIT) by:

A)   deducting taxes, adding back depreciation, and deducting the investments in fixed capital and working capital.

B)   subtracting investments in fixed capital and working capital.

C)   adding taxes, deducting depreciation, and adding back the investments in fixed capital and working capital.

Correct answer is A)

As presented in the reading: FCFF = EBIT (1 – tax rate) + Dep – FCInv – WCInv.

Q3. In computing free cash flow, the most significant non-cash expense is usually:

A)   deferred taxes.

B)   depreciation.

C)   capital expenditures.

Correct answer is B)

Depreciation is usually the largest non-cash expense.

Q4. Which of the following items is NOT subtracted from the net income to calculate free cash flow to equity (FCFE)?

A)   Subtractions to notes payable.

B)   Additions to cash.

C)   Interest payments to bondholders.

Correct answer is C)

Interest payments to bondholders are included in the income statement and are already subtracted to calculate net income.

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