I think it is Level 1 question:
CFO=NI+Depreciation+Int(1-tax rate)-change in working capital
Why add back depreciation, not depreciation*(1-tax rate)?
Why add back Int*(1-tax rate), not Int alone?
Why the initial investment for a project is investment in working capital and fixed asset, not current asset and fixed asset? Why the initial investment has to net of current liability?
Thank you!
Fixed that for you!
NI captures tax payment which is cash outflow, so the tax shield gained from deducting depreciation for tax purposes is already accounted in the tax payment. Therefore, only depreciation itself is added back.
Note that CFO does not add back interest payment!
You are confusing FCFF with CFO. In case you ask, why FCFF add back int*(1-t) and not only int ? This is because FCFF is calculated with the purpose of firm valuation. The process of valuation involves discounting free cash flows to the firm to the present with the WACC rate. The WACC already considers tax shield benefit from interest expense, so you have 2 options for a correct valuation: you retire tax shield benefit of interest expense on the cash flow, or you retire the tax shield benefit of interest expense on the discount rate (wacc). The commonly used process includes the tax shield benefit in the discount rate, wacc.
Remember wacc = We*Re + Wd*Rd*(1-t) + Wp*Rp
Where Wd is the weight of capital in debt and Rd is cost of debt. (e = equity, p = prefered stock)
Working capital is a mix of assets, some of them from equity owners and some from debt holders. A supplier is a “debt holder” because you owe it a payment. So, WK is net current assets.
For example, a retail company, say a food seller, starts its operation today. What is the investment so far? Yup, buildings (store and offices), inventory (products on sale) and liquid cash for daily operations. For capital budgeting analysis we don’t consider debt, total investment is the total asset used for operations. The building could probably be financed with a mortgage, hence its cost price wouldn’t be an initial cash outflow for equity owners. The inventory could be partially financed with credit suppliers for 90 days for example. However we can also do project analysis considering debt, but that is another story.
Hope this helps!
But for capital budgeting purpose, Int*(1-t) is added back to CFO, because it is the cost of capital.
Oh, yup, that’s right when you analyze a running company with leverage. However, in the common capital budgeting scenario, models can be created assuming no debt directly. In other words, the project IS should not consider interest expense, so no adjustment is necessary. The idea of capital budgeting is to assess the profitability (in operating terms) of a stand-alone project, new projects. Valuation, in the other hand, has the idea of valuing companies already on the run.
In my experience, the models I created so far for the company I work for include both types of analysis: levered and unlevered projects, so that adjustment you say is necessary indeed.
OK. I think for exam purpose, we always add interest back to CFO. Got it. Thank you.