FCFF = CFO + int exp(1-tax rate) - FCInvestments FCFE = CFO - FCInvestment + net borrowing Can someone explain the logic behind these two equations, such as why FCFE includes net borrowing but not int exp, and FCFF includes int exp, but not net borrowing?
Interest expense is a cash flow that goes to suppliers of debt capital. Equity is subordinate to debt, so for free cash flow available to equity needs to pay the debt suppliers first. Net borrowing can be viewed as payments to (and receipts from) debtholders. FCFE must account for this, but it would not make sense for FCFF to account for payments to/from debtholders because the measure’s purpose is to provide the funds available to them, not paid to them.
FCFF is the cash flow available to creditors and shareholders, after all operating expenditures and investments in working capital and fixed capital have been made, so the company would remain a going concern. It can also be written as: FCFF=NI+noncash charges - working capital investments + aftertax cost of interest - fix cost investments It includes after tax cost of interest because creditors have not been paid yet. FCFE is the cash flow available only to common shareholders, after all operating expenditures, investments in working capital and fixed capital, and all payments to creditors have been made, so the company would remain a going concern. It can also be written as: FCFE= NI+noncash charges - working capital investments - fix cost investments+ new borrowing - debt repayment. FCFE is after interest has been paid, debt obligations have seniority over payment to shareholders (in the form of dividends). It includes net borrowing (=new borrowing - debt repayment) because those are funds available to shareholders too, if the company took some new borrowing.
man, u need the textbook for that… it is too long anyway my understanding is FCFF is cash available to all investors, inculding stockholders and debt holders. (I don’t have ur post in front of me right now but u’ve mentioned only FCFF from CFO but u can also find it out from NI. It might help u to understadn what happens there. FCFE is CF available fro distrib to the common shareholders; net of everything hope it helps
wow map, that was THE post ! looks like an online lecture
My question is that why for FCFE, net borrowing is not deducted instead of being added. Becoz, net borrowing = Debt Issued - Debt repaid. So net borrowing reflects the amount yet to be paid to creditors which reduces the cash flow to common stockholders. Therefore, the final cash left for commonstockholders would be after paying the creditors which have a priority in case of liquidation.
because the borrowing is “net” that is why it brings in some $ to common stock holders…the book does a good job on the FCFF and FCFE sections.
I know the equation, but when referencing FCFF and the “after-tax cost” of interest, why isn’ t the entire interest expense added back, considering all this cash should be available to creditors/equity holders of the firm??
bmurphy130 Wrote: ------------------------------------------------------- > I know the equation, but when referencing FCFF and > the “after-tax cost” of interest, why isn’ t the > entire interest expense added back, considering > all this cash should be available to > creditors/equity holders of the firm?? The NI component includes an after-tax interest cost. This is why you add back interest expense after-tax in order to negate this effect in the correct manner. Does this make it clearer?
The NI component had the entire interest expense removed “above the line” though. That is where my confusion sets in! I understand that there is a tax shield associated with interest deduction, equal to the deduction times the tax rate. Help?
FCFF attempts to compute the cash available to all capital providers (debt and equity). The NI component has interest subtracted out and then the remainder is taxed. However, we want to treat the interest as though it weren’t an expense (remember, this cash is available to debt holders too!). Therefore, we want to tax the Earnings and Interest together. Which leads us to the first portion of the FCFF formula -> EBIT * (1-t) This can be further broken down into -> NI + Interest * (1-t) So I guess the answer to your question is: We don’t add the entire interest expense back because we are trying to treat as if it were earnings (which is taxed).
debt gives companies in the US tax shield. that is why the AFTER tax part of the exp is an add back in the stmt of cash flows.
ymmt and daj224, Thanks! Treating it as earnings is what makes it click for me. Now I can finally rest at night… haha. Love the forum.