All - would appreciate some help. In Kaplan study session 12, book 3, page 155, it is stated that “Dividends, share repurchases, and share issues have no effect on FCFF and FCFE; changes in leverage have only a minor effect on FCFE and no effect on FCFF.” Going through some of the Q-bank, a question reads: “Assuming that Schneider, Inc., slightly increases its financial leverage, what should happen to its firm value? The firm value should” The correct answer is “increase due to the additional value of interest tax shields” What am I missing? Apologies, going on hour 14 at work today…
I saw this too… tried wrapping my head around it.
I think they’re attacking two different areas here. By adjusting your leverage, theoretically your Free Cash Flow to the Firm will not be affected, since those additional interest payments are “free” to the bondholders.
However, once you then calculate firm value you will potentially seem some adjustments due to the lower discount rate of WACC.
That’s how I understood it
Lower WACC and increased debt tax shield is the way to look at this. Also, keep in mind that increasing leverage won’t always increase the value of the firm. At a point beyond the “optimal” capital structure, WACC should start increasing due to financial distress costs (in the real world, anyway). The firm value will decline when WACC starts to increase again.
two completely different concepts.
FCFF is fixed.
Firm value(levered) = Firm value(unlevered) + (tax * debt)
- the so called ‘tax shield’
This is how i understood it,
increase in Leverage means more debt, more debt brnigs more tax shield in NI, but looking to the formula
FCFF=Ni + NCC + int(1-t) -Cap ex - W Cap. In this, we are actually adding back the same int (1-t) that has been deducted to arrive at NI, so basically it has Net zero effect.
Now to find firm calue WACC is used and with increase in Leverage, weights would be changed as well. The havier the weight on the After Tax cost of debt Lowers the WACC and increase Firm value.
Hope it helps.
Thank you!