In the FCFF formula, (Free cash flow valuation) - why is only interest adjusted for tax. and NCC / Dep is not?
And another question on top: In the CFA book under the first EOC question of this chapter it´s being asked about the effect on the FCFF if depreciation increases by 100 (if tax rate 40%). Acc to my understanding such increase in dep increases NI by less tax ie 40 plus we would add back whole depreciation when calculating FCFF so consequently FCFF resp. FCFF should increase by 140 but according to the solution in the book it´s only increase of 40. Can somebody pls explain? Thanks
It’s been answered many times but here is one more attempt.
FCFF = cash flow to the debt providers and bond holders.
We will use the following for all the case scenarios:
Sale: 100, COGS: 50 Tax: 20%, Dep: 25, Int: 10
Case I: assume no dep or Int expense for the firm.
NI: (100-50)(1-.20) = 40.
Cash flow: + 100 - 50 - 10 =40. NI and CF is same. In absence of everything else FCFF = FCFE = CFO. Further more to arrive at CFO using NI there are no adjustments to be done, since CFO = NI.
Case II: assume only Dep.
NI: (100-50-25)(1-.20) = 20
CF = +100-50-5 = 45
In this case: FCFF = 45. Because 45 is sitting in firm’s bank and any debtprovider will assume that 45 can be used to service him.
Alternatively notice: to arrive at CFO from NI (indirect method), you have NI+NCC = 20+25. So you can see to arrive at FCFF you have to add the entirety of DEP to NI.
Now let’s say you only add DEP after adjusting for tax, so 25*(1-.2) =20. In that event your NI still 20 and you add another 20, equal to 40. In this case the debt provider will ask, you have $45 sitting in your bank, but how come you are only telling me that you have $40 to service my loan (forget the fact that there is no loan). He’ll fire you for bad accounting.
Case III: assume only Dep and Int.
NI = (100-50-25-10)(1-.20) = 12
CF = +100 - 50 - 3(taxes paid) - 10(int paid). = 37.
CFO starting from NI (indirect) = 12+25=37.
Is 37 available to bond holder, is FCFF=37? No. Because bond holders want claim to the interest also as they are the ones who are getting it anyways. So add all the interest the firm paid $10. But firm only paid effectively $8 in interest (10 of int - 2 saved in tax). Note that in case II tax was $5, and in case III tax is $3. So firm paid $10 in interest but $2 less in tax, effectively paying $8 in interest. Hence only add $8 to the interest.
so FCFF = 37+8. = 45.
Case II and Case III are same, and this should make sense cuz adding int payments doesn’t affect the FCF available to bondholders. FCFE is the one that’d go down by another 8.
I look at it this way without all the calculations: FCFF is supposed to be the cash flow available to the firm. If they arent paying that interest to their bondholders and want to keep it, the government is going to tax them for it so the only way its going to be available to the firm is if its taxed. At that point it just becomes like any other income that would be available.
As for depreciation, its not taxed by the govt so the firm gets to keep their full amount. Idk if the logic behind all that is correct obviously but it helps me remember it.