I understand that Preferred Dividends are available to FCFF and not available to FCFE. My question is this: aren’t Preferred Dividends below Net Income? The text is not very clear. Wiley basically states that if you add PD to any FCFF formula and you use FCFF to get to FCFE then you subtract it out. Similar to Int(1-t). What if we start with CFO or something? Then what do we do with preferreds? I guess I just don’t know where it sits on the Balance Sheet so I don’t know if we added it yet or not. I’ve done massive searches and can"t seem to find an answer because the text is very vague about it.
Although, preferred dividends are paid from equity position, preferred stockholders have priority over common stock holder in dividends payoff and in liquidation process. There are also various kind of preferred stocks dividend (eg. cummulative, participating etc). Since, preferred stock holders are between debt holders and common stock holders under structure of payoff, the preferred dividends should be treated as Interest in FCF with key difference that pref. dividends are not tax deductible unlikely as debt holders payoffs (interest).
Also, IMO pref. stocks issue (cash inflow to company) should be treated as Net borrowing inflow in FCFE calculation. That’ s how I consider the preferred stoch holder issue in FCF calculation.
Also, I cannot remember any question with calcuating FCF with preferred stock in CFAI EOCs nor in portal questions so I think that wouldn’t be significant chance that will appear on exam.
I have not either, but it is mentioned in the curriculum albeit vaguely with no examples to my knowledge. The part with preferred issuance being a net borrow inflow makes perfect sense. I just hope it does not come up on the exam since they do a poor job of explaining it. My guess for FCFE is: CFO has no dividends paid in the calculation so it was never taken into account so subtract preferred. NI is usually before any dividends so subtract preferred. Lastly subtract when preferred dividends were specifically added into FCFF calculation. That is what the curriculum “hints” at. Again I have seen no examples of it yet on mocks or topic Tests or EOC but it’d come up in the past.
My point of view:
FCFE from CFO with not pref.div., assuming interest on debt issue net of tax are in CFO
FCFE = CFO - FCInv + Net Borrowings
since:
Net Borrowings = +New debt issues - Debt repayment (Cash Inflow - Cash outflow)
thus FCFE with Pref.stock, assuming pref.dividends are not in CFO than in CFF
FCFE = CFO - FCInv + Net Borrowings + Net preferred (net pref. inflow-outflow (divid/repurchases))
FCFE = NI + NCC - FCInv - WCInv + Net Borrowing + Net preferred capital inflow (issuance pref-divid/repurchases)
I want to dig up the text in the curriculum but it appears that the the question on the exam should be clear on whether the NI presented is traditional NI or NI for Common Equity Holders (aka preferred dividends removed)
Once you establish what NI you are looking at you or may not need to make changes as long as the below is properly taken into account:
FCFF includes preferred dividends.
FCFE does not include preferred dividends, but does include any inflows from preferreds.
I understand we may be going past the scope of the curriculum but i would not put it past the CFA Institute to toss in some half baked questions when they barely glaze over it in the curriculum.