This is confusing me: the Schweser says: if leverage increases, it has no effect on FCFF but minor effect on FCFE. This is absolutely right if you look at the FCFF and FCFE formula. However, what I’m considering is that when you increase firm A’s leverage, you increase debt, interest paid goes up and FCFF, FCFE are both affected. Moreover: Schweser says leverage increases, WACC decreases. However as WACC = weight equity X ke + weight debt X (1-t) X kd. How the heck can it happen? Anyone helping me out here?
Interest paid shouldn’t affect FCFF at all, right. You add after-tax interest back to NI to get to FCFF, so it is independent of interest payments. In theory a firm could have 100% debt or 100% equity and if everything else was equal, it should have the same FCFF. FCFE will take a hit with increasing leverage, since you don’t add interest back for FCFE. I guess I’m not clear on the confusion for WACC, but the after-tax cost of debt is almost always less than the cost of equity (and should be), so adding debt should reduce WACC.
yeah more debt doesn’t affect FCFF as FCFF is computed before any transactions related to bondholders are done. and as leverage increase, WACC decrease, because more leverage, raises your debt-equity ratio, and we know that for every 1% increase in tradeoff between debt and equity, the WACC goes up on only 1-t if you add 1% to debt, or goes up by 1% if you add it to equity.
NTP, it sounds like you’re confusing actual FCFF to the valuation of FCFF - a change in leverage will not affect the calculation of the FCFF at all (as stated by Janky, and for those exact reasons), yet your WACC will decrease (99.99% of the time), which means that on a valuation basis, your firm will be worth more. Summing it up, the actual calculation of FCFF does not change, just the discount rate that you’re applying to it to value the firm.
skillionaire Wrote: ------------------------------------------------------- > NTP, it sounds like you’re confusing actual FCFF > to the valuation of FCFF - a change in leverage > will not affect the calculation of the FCFF at all > (as stated by Janky, and for those exact reasons), > yet your WACC will decrease (99.99% of the time), > which means that on a valuation basis, your firm > will be worth more. > > Summing it up, the actual calculation of FCFF does > not change, just the discount rate that you’re > applying to it to value the firm. good explanation sk …always helps to recall the various FCFF/FCFE formulas
skillionaire, janky - not a related question – when you have shifting leverage scenario - I remember reading the FCFF is a better method to use. Is this because of the above: WACC would be more representative of the firm’s cost of capital. VFirm goes up - and then you remove MV(Debt) to get to value of equity?
cpk123 Wrote: ------------------------------------------------------- > skillionaire, janky - not a related question – > > when you have shifting leverage scenario - I > remember reading the FCFF is a better method to > use. Is this because of the above: WACC would be > more representative of the firm’s cost of capital. > VFirm goes up - and then you remove MV(Debt) to > get to value of equity? FCFF is a better measure for shifting leverage structure. my thoughts as to why is the MM static theory of cap structure
FCFF is a less volatile measure than FCFE, as (in a shifting leverage scenario) firms are always paying off debt, issuing debt, etc., which will lead to large fluctuations in yearly FCFE, whereas FCFF is much, much more stable. Don’t think it’s related to the WACC so much (although the WACC would clearly change), more so to the fact that a billion dollar bond offering would increase your FCFE by a billion that year, and then you pay off a 400MM bond next year, etc. - you can imagine what this will do to the volatility of the FCFE. Hope this helps.
right… thanks… real good discussion this.
CPK, to answer your question (which I’m sure you already know), yes, you get the equity value by discounting FCFF at the WACC and then subtracting out the MARKET VALUE of debt (make sure not to use book value, they’ll most likely give you both).
skillionaire Wrote: ------------------------------------------------------- > CPK, to answer your question (which I’m sure you > already know), yes, you get the equity value by > discounting FCFF at the WACC and then subtracting > out the MARKET VALUE of debt (make sure not to use > book value, they’ll most likely give you both). hmmmmmmmmmmm…thanks goood reminder sk