When calculating FCFF why is all of NCC added back and only the after tax portion of interest. Doesn’t depreciation offer the same tax shield that interest does?
INT(1-TR) is what was backed out from NI number when you calculated Net Income. This is the income to the bondholders so you need to addback the exact same number ‘INT(1-TR)’ to get back to the income available as a whole to all the creditors. DEP was Operating expense and was deducted from NI, without tax consideration. So we need to addback DEP and not DEP(1-TR)
Depreciation is deducted from NI with tax consideration because it is deducted before tax is calculated. That is why accelerated depreciation results in a lower tax bill in the early years.
Sales = 20 COGS = 5 Depreciation = 2 Oper Income = 20-5-2 = 13 Int expense = 5 Income before taxes = 8 Tax rate = 0.4 Net Income 8*(1-0.4) = 4.8 Now add back non-cash charge of depreciation. We add back the full amount that was deducted to reduce taxes payable. Depreciation in its entirety was a non-cash deduction. Now, for interest expense. Let’s suppose there is no interest expense Income before taxes would be 13, Net Income would be 13*0.6 = 7.8. However, in this case the interest expense is actually payable, meaning it is a cash expense. How much is that expense? Int*(1-tax rate) 7.8 -Int*(1-tax rate) = 7.8 - 5*(1-0.6) = 4.8 Interest expense is a cash flow available to one of the company’s capital providers. So we add it back to get free cash flow BEFORE payment to bondholders, and deduct it to get free cash flow left for equityholders
Using your example only w/o depreciation: Sales = 20 COGS = 5 Oper Income = 20-5= 15 Int expense = 5 Income before taxes = 10 Tax rate = 0.4 Net Income 10*(1-0.4) = 6 Therefore the existence of depreciation only reduced NI by 1.2. Shouldn’t this be all that we add back? Wouldn’t we be double counting 0.8 of it by adding the whole thing?
No, because that depreciation expense in its entirety does not affect cash flow, whereas the after-tax interest expense is what is actual cash payment to bondholders (assuming that you also correct for amortization effects)
Depreciation is virtual money- Govt does not put takes on that virtual money. Nothing really came in or went out of the door, per say. Interest Expense is actual flow of cash - so govt has it’s share in there.
I don’t know why I am having so much trouble with this and I know its not a big deal because I will know the correct formula for the exam, however let me ask this another way. I understand the concept of adding back depreciation because no cash actually went out. Similarly why not add back the entire interest expense because all of that interest actually went out but it went to bondholders who are included in FCFF.
Think of it this way depreciation*tax rate = this is the amount of money you’ve saved from paying less taxes depreciation*(1-tax rate) = this is the amount of money you didn’t pay any cash on Add the two together, you get depreciation in its entirety interest expense*tax rate = this is the amount of money you’ve saved from paying less taxes interest expense*(1-tax rate) = this is the amount of money you will pay cash on Note we deduct interest expense*(1-tax rate) for FCFE because we’ve paid this to bondholders
Ha ok one more point and ill let it drop. depreciation*tax rate = this is the amount of money you’ve saved from paying less taxes --> these savings are already reflected in NI so why add this back?
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I have the same question.
Why the entire depreciation is added back in calculating free cash flows when infact depreciation results in tax savings for the company? Why can’t we just add back dep(1-t)?
Cos depreciation is a non cash charge in the first place. Interest costs reduce your cash flow, depreciation doesn’t.
So what if it is a non-cash charge? It is resulting in cash savings for us as we are paying less taxes.
First post - had to comment:)
In your question you must think of two critical ideas:
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for FCFF, you are trying to determine what capital is FREE to distribute to both types of “owners” of the companies assets. The owners are either the lenders or the shareholders. For FCFF, you are trying to determine the free cash that is available to either pay back lenders in either principle or interest, or pay shareholders. The term free here is key, because you can consider it the cash that is available after you have re-invested in both fixed assets and working capital in order to sustain operations.
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You must understand how to arrive at FCFF from different points in the financial statements. In your question, you are started at Net Income.
The process is then simple for why you add back the aftertax interest, but not depreciation.
Starting at Net Income of 1000
Depreciation is 200, Investment in Fixed Assets is 100, Change in Net working capital is 50.
To get FCFF, we need to first arrive at operating cash flow (Net income + depreciation) = 1000 + 200
1200 = operating cash flow, which still includes interest. Lets say we don’t adjust for interest first and calculate FCF = 1200 - fixed assets (100) - change in NWC (50) = 1050
We now have FCF, but the problem is that this is not considered FCFF, because this is free cash flow after we have still paid the interest to our lenders. This is not Free cash flow before we paid all of the owners of the companies assets in some form.
So to adjust for this, we need to add back the interest. However, if we didn’t pay the interest at all, the company would not have also received the tax shelter from the interest payment. Therefore we need to add back the after-tax interest payment to get to FCFF, free cash flow before paying out in any form to any “owner” of the companies assets.
So now we can add the after-tax interest add-back to our formula and get
Net income + depreciation (operating cash flow) - investment in fixed assets - changein net working capital + after tax interest payments to lenders.
Hope this makes more sense.
FCF is Free cash flow to the firm. The way I take it is depreciation is something which the firm is reducing in total and it has it in cash so we add it back completely. Whereas tax is paid in cash so the benefit which they get is only of ater tax cost of interest that is why it is added back to know the free cash flow to the firm.
Interest expense involves a cash expense, partly offset by the tax savings. with depreciation there was no cash expense to start with, so it affected Net Income and cash flow in different ways. Eg: Depreciation: -$100 tax savings from depreciation: +$10 Overall effect on net income: -$90 Overall effect on cash flow: +$10 To get these numbers to match you add back ALL of the depreciation. Whereas with interest expense: Interest cost: -$150 Tax savings from interest: +$15 Overall effect on Net Income: -$135 Overall effect on cash flow: -$135 The effect of the transaction is the same on both cash flow and NI so you just add back to reverse the effect of the transaction (ie add back interest costs adjusted for taxes).
Ok thank you guys. I guess i have gotten it now.
So depreciation and interest both results in tax savings for the company. Tax savings means we are paying less in cash so it basically should increase the cashflow.
With depreciation, the transaction that is trickling down to NI is effectively Dep x (1-tax). When we add back the full depreciation amount in calculating free cashflows then the part of it offsets the dep x (1-tax) component and the remaining part serves to increase the cash flow (which are basically tax savings).
In case of interest, the transaction that is trickling down to NI is effectively int x (1-tax) due to tax savings. But since we pay the interest in full so that tax savings get offset with the int x (t) component. Therefore we only have to add back the int x (1 - tax) component in calculating free cashflows.
Phew!
Depreciation is added back because it affects Net Income, but is not an actual cashflow. So when calculating FCFF and FCFE, it needs to be added back by the after -tax amount that depreciation decreased NI by.
Interest is added back because for the purposes of FCFF, it is a financing (not operating) cash flow. Financing cashflows are not included in FCFF, as the purpose of finding FCFF (and FCFE) is to calculate how much cashflow generated by normal business operations can be distributed to the contributers of capital to the business (ie, the people who provide debt and equity to the firm).
thanks for this. i think you expained it best.