# Calculating FCFF from EBIT - Interest Tax Shield

In the notes, the formula for arriving FCFF from EBIT is as followings:

FCFF = [EBIT X (1 - Tax Rate)] + Dep - FCInv - WCInv

• FCFF = Free cashflow to the firm
• EBIT = Earnings before interests and taxes
• Dep = Depreciation
• FCInv = Capital investments
• WCInv = Working capital investments

The point I do not get from this formula is that why is not the tax shield from paying interest being added back. It is a real benefit to the firm.

Thanks.

As you wrote:

“EBIT = Earnings before interests and taxes”

EBIT is before charging interest expenses, so why would you need to add back something that haven’t been charged.

Like calculating FCFF from EBITDA, depreciation tax shield is added back even when depreciation is not added back.

I do not understand why interest does not get the same treatment.

The difference in the treatment is conceptual. FCFF is the cash flow available to owners and lenders, so we don’t subtract interest expense (cash outflows) when calculating FCFF from EBIT or EBITDA and we do add back interest expense after tax when calculating FCFF from NI. FCFF is the cash flow before dividend distributions and before loan payments (including interest). This is why FCFF is used to value the whole firm, not a specific ownership % share like FCFE is intended to, for example.

The calculation about depreciation is just mathematical. Depreciation or amortization is not a cash outflow even in the most bizarre building of a cash flow calculation, so it will always be an adjustment depending what is your start point.

Hope this helps.

NI = EBT – Taxes = EBT – (EBT × Tax Rate) = EBT(1 − Tax Rate)

NI = (EBIT – Int)(1 − Tax Rate) = EBIT(1 − Tax Rate) – Int(1 − Tax Rate)

NI + Int(1 − Tax Rate) = EBIT(1 − Tax Rate)

Therefore,

FCFF = NI + Int(1 − Tax Rate) + Dep − FCInv – WCInv

FCFF = EBIT(1 − Tax Rate) + Dep − FCInv – WCInv

It’s called . . . wait for it . . . algebra.

This really helped me conceptually:
The essence of free cash flow is to determine the cash flow that is available to repay creditors or pay dividends and interest to investors.

"Interest Tax Shield Example:
A company carries a debt balance of \$8,000,000 with a 10% cost of debt and a 35% tax rate. This company’s tax savings is equivalent to the interest payment multiplied by the tax rate. As such, the shield is \$8,000,000 x 10% x 35% = \$280,000. This is equivalent to the \$800,000 interest expense multiplied by 35%.

The intuition here is that the company has an \$800,000 reduction in taxable income since the interest expense is deductible. This reduces the tax it needs to pay by \$280,000.