Having a hard time conceptualizing why we add back interest net of tax to FCFF.

CFA Level II
#1

I can plug the numbers into the formula pretty easily, but I really want to be able to conceptually understand this and I think I’m missing the point.

Lets take FCFF to mean all available (free) funds to bondholders and shareholders…

Now lets assume a pretty simple example

EBITDA —> $150

Depreication —> $50

EBIT —> $100

Interest Expense —> $10

EBT —> $90

Tax Rate —> 30% (27)

Net Income = 63

Let’s further assume we have no FCinv or WCinv… therefore

FCFF = 63 (NI) + 50 (Dep) + 10*(1-.3) (Interest Net of Tax) = $120.

So, I guess the part that confuses me is why are we adding back just the $7? It’s as if the more interest we have, the higher tax savings we obtain (which I assumed was a plus for FCFF)…

It almost seems as though it should be Interest Expense(1+T). Why does our tax shield from having interest expense on our income statement reduce our FCFF?

Can someone really just dumb it down for me – simply stating that it’s net of tax doesn’t really do it for me. Thanks

#2

FCFF is the cash flow that we can use to pay all of our suppliers of capital: shareholders and creditors. Therefore, we want to know how much cash we had before paying interest (or, put another way: how much cash we would have had if we hadn’t paid any interest).

Let’s say that our CFO is $100, we paid $10 in interest, and our tax rate is 30%. If we hadn’t paid any interest, then we wouldn’t have had that $10 outflow, so we add that to CFO to get $110. However, if we hadn’t paid any interest, we wouldn’t have had a $10 tax deduction, so we would have had to pay $3 (= $10 × 30%) additional in taxes; we deduct that from the adjusted CFO to get $107.

1 Like
#3

And just like that it makes sense – Thanks for the help, once again.

#4

Cool!

You’re quite welcome.

#5

You’re adding after-tax interest to net income because that net income ALREADY has the “tax savings portion” in it. If you added the whole entire interest, you would double count the tax savings.