Explanation

Free Cash Flow to the Firm (FCFF) can be calculated using the following formula:

FCFF = CFO - Capital Expenditures + Interest × (1 - Tax Rate)

Where:

• CFO = Cash Flow from Operations = $500 million
• Capital Expenditures = $40 million
• Interest = $20 million
• Tax Rate = 25% = 0.25

Calculation:

1. Interest after tax adjustment: Interest × (1 - Tax Rate) = 20 × (1 - 0.25) = 20 × 0.75 = $15 million

2. FCFF = CFO - Capital Expenditures + Interest after tax FCFF = 500 - 40 + 15 = $475 million

Alternative formula: FCFF = CFO - Capital Expenditures + Interest × (1 - Tax Rate)

Why this formula?

• Free Cash Flow to the Firm represents cash available to all investors (both equity and debt holders)
• Interest expense is tax-deductible, so we need to add back interest after tax
• Capital expenditures are subtracted because they represent investments in long-term assets
• Net borrowing is not included in FCFF calculation as it's a financing activity

Verification:

• Option A (460) would be CFO - Capital Expenditures = 500 - 40 = 460 (incorrect - ignores interest)
• Option B (470) would be CFO - Capital Expenditures + Interest = 500 - 40 + 20 = 480 (incorrect - doesn't adjust for tax)
• Option C (475) is correct: 500 - 40 + 15 = 475