Hi All,
Can someone explain to me the concept of adding back “interest x (1-T)”
maybe i’m just misunderstanding something. FCFF is valuation before you pay back the debt holders right?
what does it mean when you add back that interest x (1-T). I read the schweser notes but for some reason i can’t connect the dots. Can someone take the time and explain it to me using language even a random person off the street would understand it?
thanks and goodluck studying everyone!
NI is net income of company After paying off interest to debt holders (i.e. we subract interest expense to reach net income).
FCFF is cash flow of firm Before paying back interest to debt holders.
so when we calculate FCFF starting from NI, we have to add interest back because we are assuming we have not yet paid interest (yet to pay) to debt holders…
hope it help.
that indeed helps… Don’t know why I couldn’t connect the dots… but thanks.
mine also explaining the part why we only take (1-T) , I think it’s because that’s the amount actually taxed correct?
I have a connected question in this regard. In the chapter of capital budgeting, while valuing the company, they do not add back the interest to value the company. I did get the interest explanation above but am not clear when you add the interest cost vs. when you dont. Thanks in advance!
hey rayjay,
to shed a bit more light into the “intuition” of why we want to add-back after tax interest, remember that the reason for calculating FCFF, is to determine the value of the companies operating assets. The quesiton to ask is “regardless of how you would finance these assets, how much cash can these assets generate?”
Once you have this number, calculating the value of the equity is simple, by simply subtracting the value of the debt used to finance these assets.
To further this thought, remember that the value of the assets is independent of the interest payments that are needed to service the portion of the debt used to finance them. They could be financed in an infinite number of ways… (ie. equity, preferred equity, debt, convertible debt etc.)
So now, if the point of FCFF is to determine the value of the operating assets independent of the interest payments used to finance them, then in order to arrive at FCFF we must first unlever the cash flows by adding back interest expense.
The complicating matter is when we try and arrive at FCFF starting from net income. First remember that net income is after tax, and hence we have already realized the tax shield of the interest income. For example, lets say interest expense is 100 and the tax shield is 30. To unlever the operating cash flow, starting with net income, we must back-out both the interest expense and the tax shield of the interest expense, so we must add back 100 of interest and -30 of the interest tax shield for a total add-back of net 70.
I hope this makes sense. Cheers.