FCFF and Interest Expense

CFA Level II Equities
#1

Hi,

Got a bit confused about FCFF and interest expense. Please see the 2 situations below:

A. assuming 100 cash revenue, 0 interest expense, 0 depreciation, 0 capital investments (long term and short term):

so tax = 30 (assuming 30% rate), net income = 70, FCFF = NI + (1-t) * Int + 0 + 0 + 0 = 70. Makes sense to me.

B. assuming 100 cash revenue, 100 interest expense , 0 depreciation, 0 capital investments (long term and short term):

so tax = 0 (nterest is tax deductible), net income = 0, FCFF = NI + (1-t) * Int + 0 + 0 + 0 = 70.

But given no tax paid, 100 cash revenue should all be used to pay bond holders, so FCFF should be 100?

What is missing in B? Thank you very much.

#2

You can’t pay bond holders if you are calculating free cash flow to firm and since you won’t be paying bond holders, you must pay (30%)*100 amount of tax. This will make your FCFF = 70

#3

Thanks.

But I am not sure I understand “You can’t pay bond holders if you are calculating free cash flow to firm”.

Isn’t FCFF the cash available to bond investor and equity investor, after tax and cash investments?

And I showed in the calculation that tax = 0, why do I need to pay tax again?

Thank you.

#4

bump

#5

FCFF is the money before debt payments.

Cash flow to Firm: This cash flow is before debt payments but after operating expenses and taxes. This looks at not just the equity investor in the asset, but at the total cash flows generated by the asset for both the equity investor and the lender.

#6

Thanks rawraw.

But my question wasn’t about FCFE vs FCFF. It’s about FCFF under different interest expense.

For the B situation, I seem to get 2 conflicting answers when looking from 2 perspectives, but don’t know what’s missing.

Can someone point out what is wrong with my calculation? Thanks.

#7

I think you have to remember that this is equity valuation and not the accounting section.

Isn’t the purose of adding back the (int X (1-t)) to bring you back earnings before you took the interest deduction?

What if you were to look at it using another FCFF model.

EBIT(1-t) + Dep -WCinv - FCinv? Both formulas get you to 70.

Though with the 100 interest expense, it looks like you are paying out more than the actual free cash flow.