Please help me figure out why we don’t add back tax shield from interest expense in this FCFF equation.
It seems like if we account for the depreciation tax shield by adding Depr*Tax, then we should also do the same for interest expense by adding Int*Tax.
FCFF = EBITDA(1-t) + Depr*Tax - FCInv - WCInv
Other forums suggest that depreciation is non-cash while interest expense is an actual outflow, but this doesn’t seem to answer the question because we are talking about the tax shield benefits created, regardless of the nature of the expense.
Conceptually, you should just go back to the definition (or rather, the name) of FCFF - it represents the free cash flows available to the firm, i.e. to equity holders AND bond holders. So conceptually, this is the free cash flow, which is obtained before paying bond holders’ interest, so before having the right to the respective tax shield as well.
You would find that in FCFE, which is free cash flow to equity holders only (i.e. AFTER paying bond holders interest and/or principal), the tax shield from the interest expense is indeed included.
Thanks! This makes sense intuitively. Depreciation tax shield is benefits to both equity and debt holders, whereas interest tax shield only benefits the equity holders (i.e. the firm). Therefore, we don’t account for it in FCFF. We do, however, account for it in FCFE.