I don’t understand why net interest outflow(1-tax rate) is added back to CFO to get Adjusted CFO; I know that this is an issue for me, also with understanding why you add int exp(1-tax rate) in the FCFF formula. Schweser says, “The limitation of CFO, however, is that it includes items related to financing and investing activities. Therefore, analysts often adjust CFO by adding back the after-tax interest cost.” (Book 4, Page 249) But US GAAP treats int expense as a cash flow to operations, so why add this back if it’s already included in CFO? -Richard
I think you answered your own question. Interest Expense is related to Financing and Investing activities, but is accounted for as an operating cash flow. Since you don’t want any financing/investing cash flows affecting CFO, you must add back the after tax interest expense.
We have to be careful with IFRS though, since interest expense is either allocated to financing or operating activities. Page 473 CFAI, footnote 52
But CFO refers to cash you are receiving for operations, right? So why would a cash outflow like interest expense be added back to CFO if int expense is a CFO cash outflow?
Because interest expense is related to how the business is financed, not underlying operating fundamentals. If we want to contrast companies using a comparable valuation approach, we have to compare apples to apples - the raw cash accumulation of a business - rather than how that company is financed.
Perhaps you are getting confused in that when calculating CFO originally you take off the interest expense-this is a cash outflow. For FCFF we shouldn’t include this as its not really an operating activity its a financing. So we adjust for it by adding the interest expense back.
fcff = free cash flow to the firm think of the firm in the context of its capital structure. in other words, how much free cash flow is available to the capital structure. if you were considering the acquisition of a firm, you would want to know how much cash flow is available to all aspects of that capital structure. So since interest expense lowers CFO, and its a payment from the business operations to the capital structure, you would want to add it back in to show how much cash flow is available to the firm. Netting it for taxes is to remove the debt tax shield created by financing decisions- ie if you didnt have $100 in interest expense your after tax free cash flow would go up by less than $100.