Why do we add back Interest Expense (1-t) in FCFF?
I know this question has been asked many times, I’ve reviewed all answers, but my confusion has remained the same. I know FCF = *Cash* flow available to debt and equity holders.
I am genuinely confused on why I would add back interest expense. Moreover, I know the concept of tax shield, but I want to know how it is adapted in this context. I do however understand why we add back depreciaiton.
I usually try to solve these problems by applying generic examples, but I will apply one now and show you where i’m confused:
Assume: Interest = 800,000; Depreciation = 2,000; Tax Rate = 10% ………. This would mean we have a tax shield for interest of 80,000 and tax shield for depreciation of 200. Now FCF says I have to add back Int(1-t); so I am adding back 720,000 worth of Interest.
1) Why did I add back 720,000 and not 800,000? It is as if the tax shield hurts a debt holder as the company’s value becomes less after we include the tax shield
2) When projecting, Is Interest Payable included in the NWC equation? In FCF we have to include the change in NWC, so if we see an increase in Interest Payable, do we add include that as well or would it be double counting to include it as an interest expense and in the NWC? Also what happens if in our projections Interest payable decreases?
3) If we do add back Interest(1-t), what happens to the WACC we use to discount? Do we still do Wd*(Cost of debt)(1-t) or do we only use Wd*(Cost of debt) portion?
4) Why dont we account for the tax shield that depreciation creates?
Thank you, I am genuinely and utterly confused …
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