Hello, I really do not understand why we must make a tax adjustment when adding interest to NI to arrive to FCFF. Basically we are adding tax burden to the company on top of the calculated corporate tax. Please help.
it’s just NI+ Interest(1-T). Interest was already deducted in getting to NI. But we want to add it back. But not all of it, just interest after tax right?
I am leaving out the other adjustments btw
I did some searching and I came up with the following intuition. FCFF is calculated not to see what cash is available for equity and debt holders, but primarily to evaluate the firm value by discounting it using WACC. And WACC removes the tax shield by reducing the interest rate by tax rate to bring equity and debt on equal footing. So FCFF/FCFE must ignore the cash savings above what is reflected in WACC for debt because that belongs to Debt holders alone. And the tax shield savings is already reflected in NI because interest expense is not taxed at all.
Janardhanc, if I understand you right. We do not add back the whole of the interest, but only interest x (1-t) because at the time the cash flows will be discounted the cost of debt will include the tax savings, so we need to remove the tax savings linked to the interests when computing FCFF.
Yes. Consider we have $100 debt at 10% with 40% tax rate and required rate on equity is 15% with 50% D/E. The interest rate after adjusting for tax is 6%. WACC=7.5+3=10.5%. Only 6% interest rate is proportionately reflected in WACC so that is added back to FCFF. Meaning, 6% of interest belongs to all capital providers (both Debt and Equity holders as reflected in WACC), the remaining 4% is not reflected in WACC and belongs to Debt holders alone. Does this mean that all the tax shield savings are eventually paid back to debt holders? Nope. The debt holder receive just what they bought, the 10% interest, no less and no more. Then who is benefiting? Equity holder. How? Higher required rate of return. If you consider a 0% tax then you will just need to add back the whole interest expense.
In my opinion, the above responses are way more complicated than they need to be. The bottom line is fcff is used to identify the cash available to all providers of capital, which includes debt holder s. So we add back the interest component because thats whats available to all providers of capital. We use the aftwr tax amount because of the tax shield. note, that we may not actually add it back of the firm is reporting under IFRS and they include the interest component in financing activities. (typed on my phone)
I agree, thanks. nielsendc Wrote: ------------------------------------------------------- > In my opinion, the above responses are way more > complicated than they need to be. The bottom line > is fcff is used to identify the cash available to > all providers of capital, which includes debt > holder > s. > > So we add back the interest component because > thats whats available to all providers of capital. > We use the aftwr tax amount because of the tax > shield. > > note, that we may not actually add it back of the > firm is reporting under IFRS and they include the > interest component in financing activities. > (typed on my phone)
the part he is asking about is why the tax shield does not get added back, but I agree with you nielsen. to expand on what you said: you are looking for cash flow effects and therefore you only add back the after tax effect because your tax savings (the t * int exp) is already in net income.