Fargo’s largest competitor has a very little debt in its capital structure. In order to facilitate comparisons between Fargo and this competitor, Scott adjusts Fargo’s reported cashflows for the interest expense included in the Net Income. The most likely result of this adjustment on Fargo’s reported cashflows will be: Fargo follows US GAAP for the presentation of financial statements. A) Lower cashflows from operations (CFO) and higher CFF. B) Higher CFO and lower CFF. C)lower CFF and unchanged CFO. Please explain.
Interest expense in NI is included in CFO for US GAAP - and reduces CFO. So adjustment - would be to remove it from CFO, (so CFO Increases) and make the adjustment to CFF to CFF reduces (because it is an expense). So B) Higher CFO, Lower CFF.
Fargo has more debt, so IE is high. This IE is included in NI, so NI reduced After adjustment - Analyst need to remove the excess Debt to make it comparabe with his competitor. Hence adds backs IR to CFO (which took an hit initially) and increases CFF by the same amount. B
Fargo already reports higher interest expense because of higher debt in capital structure. This makes Fargo report lower CFO right now. (This will reduce the NI and eventually the cashflow). To compare with lower debt company, Lower debt --> lower interest expense --> higher NI --> Higher CFO. CFO will be adjusted by adding after tax interest expense. Further, Low debt means also lower net borrowing which will reduce the CFF. CFF should be lowered by the same amount. This is my logic, please confirm if I’m missing something ? Ans (B)
^correct
Wait…I think, in Charu’s statement, “CFO will be adjusted by adding after tax interest expense” should read “…subtracting after tax int exp.” NO?
it is already subtracted - so you need to add it back… if that makes things clearer.
^yup, of course.
This question appeared in book 7 test 1 AM section synthesis vignette. Although I got the answer correct, I wasn’t quite sure of the intuition. Thanks again.