match with the formula (EBIT (1-t) + DA - Capex - Inc in WC)
For simplicity, let’s assume a firm that has all sales and expenses (even tax) in cash and that there is 0 capex for a particular year. Now that Capex and Inc in WC are both 0, let’s proceed
Why don’t both FCFF figures match (manual vs formula) ? If one were to count the cash at the end of the year, they would have $61.65 which is also the cash available to lenders and equity holders.
I’ve been told that in the manual method, I’m taking into account the tax shield and FCFF is supposed to exclude the effects of capital structure. But again, the cash that the company would have with it at the end of the year would be $61.65, correct? And shouldn’t this cash be called the FCFF?
Yes, I know that. But why do I add that back? If I do add it back, it wouldn’t be a correct representation of the actual cash I would have in hand at the end of the year.
You add it back because you paid less in taxes than you would have had you not had the interest expense.
And it is, in fact, a correct representation of the actual cash you have on hand at the end of the year.
I suggest that you go through the accounting and tot up the balance in your Cash account. It’s a good exercise in general, and it will go a long way to fixing these ideas in your mind. Sincerely: it’ll help tremendously.
This cash at end does not consider interest payment for debt holders ($4). Therefore, do not also consider the tax shield gained from that $4 expense. The correct tax payment for FCFF calculation would be 28.35 + 4*0.35 = 29.75.
FCFF = 100 - 10 - 29.75 = 60.25
Now the question of the million… why FCFF does not consider the tax shield gained from interest expense? Well, FCFF is a cash flow measure for valuation. If you want to really now what is the real cash flow of a company [the one that matches ending cash balance], you must use the Total Cash Flow calculation: CFO + CFI + CFF.
FCFF is used for valuation purposes. As you said above, FCFF is cash flow for debt holders and equity holders, so it does not considers the interest payment effect, nor the benefits related to it. Once we have made this choice… (wow a choice?) Yup, we made the choice to calculate it that way, simply because FCFF will be discounted to present using WACC rate which already considers the tax shield benefit of interest expense:
WACC = we*Re + wd*Rd*(1-t)
So, if FCFF did consider the interest expense and its tax shield, the WACC would double-count this benefit. Put it whatever you want, on the discount rate or inside the cash flow, but not on both.