FCFE/Debt question

At the end of 2007, Meyer Henderson, CFA, prepared a 10-year forecast of free cash flow to equity and FCFF from 2008 to 2017 for Trammel Medical Supplies. In early 2008 Trammel unexpectedly announced a new 15-year issue of senior debt. The proceeds are expected to be used to repurchase common stock in the open market during 2008. As a result of the unexpected debt issue, Henderson should most likely: A. increase his FCFF forecast for 2008 and decrease his FCFF forecast for 2009 through 2017. B. Decrease his FCFF forecast for 2008 and increase his FCFF forecast for 2009 through 2017. C. Not change his FCFF forecast for 2008 and also not change his FCFF forecast for 2009-2007. Schweser gives answer C, but isn’t the market value of the firm (FCFF) equal to market value of equity+debt? If there is a 15-year issue of senior debt, doesn’t that increase the FCFF forecast? Schweser says no, because “changes in leverage are uses of cash that do not affect FCFF” because this debt counts as a financing decision, and FCFF does not include financing decisions. How do I know when to add debt to FCFE to get FCFF and when not to?

FCFE = FCFF - Int(1-T) + Net Borrowings. So increase in debt would only increase the FCFE forecasts - not the FCFF forecasts. In this case - an issuance of debt - will not make any changes to the FCFF valuation built up by Henderson. FCFF would not change, but FCFE would… and this (forecast of FCFF) is specifically what is being asked for in this question… does that make sense?

So they are issuing bonds and repurcsing stocks, in short, they are rebalancing their capital structure. Since FCFF is the cash flow to all the suppliers to the capital, it doesn’t really matter. I think on a side note - FCFE will be affected by capital structure changes

FCFE will be affected by capital structure changes for two reasons: 1.) Because int*(1-tax rate) will increase subsequent to the new debt issues. 2.)Net borrowing goes up. For the time being, the cash inflow from borrowing money is cash available to equity holders. In subsequent periods that will have to be paid back hopefully through cash made through the business operations. This results in a decrease in net borrowing (remember net borrowing = new debt issue - principal repayments). Also interest expense of the new debt will erode cash flow available to equity holders - but this will occur in the future.

Thank you guys. You mentioned that FCFE would be affected in part by the int(1-tax rate) term and the fact that interest on net borrowing would increase the int(1-tax rate) term, thereby decreasing the FCFE. Fair enough, but FCFF also has an int(1-tax rate) term in it, so wouldn’t the issuance of new debt lead to (in the future anyway) increased interest expense that would increase FCFF?

that you remember first gets deducted to arrive at Net Income - then gets added back for FCFF.

I don’t understand–what gets deducted to arrive at Net Income? Isn’t FCFF=Net Income+Non-Cash Charges+int exp(1-tax rate)-fci-wci? So an increase in debt means an increase in int exp(1-tax rate) means FCFF should increase…

right but interest is deducted from EBIT to get to net income. so when you’re calculating FCFF you are just adding that back, so Int basically cancels out.

ah ok so since the FCFE formula is subtracting the int exp(1-tax rate) and thus changing the FCFE, the int exp(1-tax rate) is already “built in” to the formula, so the int exp(1-tax rate) does not effect the FCFF? Whatever…I’ll just memorize it. Don’t have to understand it as long as I know what to do :slight_smile: