Explanation

Free Cash Flow to the Firm (FCFF) is the cash flow available to all providers of capital (both equity and debt holders) after accounting for operating expenses, taxes, and investments in working capital and fixed assets.

Let's analyze each statement:

A. is a measure of the firm’s dividend-paying capacity.

• This statement is accurate. FCFF represents the cash available to all capital providers, and after paying debt holders, the remaining cash (FCFE - Free Cash Flow to Equity) can be used to pay dividends. Therefore, FCFF indirectly relates to dividend-paying capacity.

B. increases with an increase in the firm’s net borrowing.

• This statement is accurate. The formula for FCFF can be expressed as: FCFF = EBIT(1 - Tax Rate) + Depreciation - Capital Expenditures - Change in Working Capital However, another way to calculate FCFF is from FCFE: FCFF = FCFE + Interest Expense(1 - Tax Rate) + Principal Repayments - New Debt Issues An increase in net borrowing (new debt issues minus principal repayments) would increase FCFF.

C. is significantly affected by the amount of dividends paid by the firm.

• This statement is least accurate and therefore the correct answer. Dividends are a distribution to equity holders and do not affect FCFF. FCFF is calculated before considering financing decisions like dividends. Dividends are paid from FCFE (Free Cash Flow to Equity), not FCFF. The payment of dividends does not change the firm's operating cash flows or its investments in fixed assets and working capital, which are the primary determinants of FCFF.

Key Concept: FCFF focuses on operating performance and investment decisions, while financing decisions (like dividends, share repurchases, or debt issuance) affect how the cash is distributed but not the total cash flow available to the firm.

Correct Answer: C