Hello,
In the free cash flow reading, equity book
Schweser says, changes in leverage have only a minor effect on FCFE and no effect on FCFF.
I dont get it, if FCFF is calculated as : NI + NCC + INT*(1-TAX RATE) - WCInv - FCInv
So interest paid (which increases with debt/leverage) clearly does effect FCFF calculation as its added on the after tax basis.
Definitely looks confusing but it’s actually pretty simple. The rationale is that interest net of taxes is accounted for above the line (i.e. within Net Income), so you’re adding that amount back in to calculate FCFF essentially as a contra entry. Effectively if leverage increases Int(1-t) will increase, however there will be an offsetting reduction in Net Income. Does that make sense?
Fundamentally leverage will not affect FCFF as it is a measure of the FCF available to all providers of capital. Adjusting the debt/equity mix is essentially irrelevant with respect to the overall quantum of FCF, rather it simply affects the allocation of FCF between equity and debt providers.
Changes in leverage will however have an effect on FCFE, as positive Net Borrowing will increase the amount of cash available to equity holders. All things being equal, subsequent periods should see a negative impact on FCFE relating to the increased interest repayments required to service the higher debt load.
Hopefully that helps out a little!
Howdy.
It doesn’t affect FCFF.
To see why, do an experiment. Compare Company A and Company B, assuming that revenue, COGS, interest, and taxes are all cash:
Calculate FCFF for Company A and for Company B. How do they compare?
Please show your work.