This write-up is motivated by a heated discussion on the Analyst Forum (FCFF - depreciation), around several attempts to explain why when calculating the FCFF, we add back the after-tax Interest expense but when it comes to depreciation, we add it in full.
Hopefully, my explanation can finally put this matter to rest. Feel free to contact me if you need any clarifications or you wish to challenge my reasoning; any debates or comments will be highly welcomed.
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The best way to understand this is to focus on the Total Cash Position available and NOT on accounting figures; and also recognize the differences in situations when cash actually flows in and out of the company and when cash is moved around within the company and still available to the company.
The confusion arises from the representation on the PnL Statement which portrays Depreciation to have a similar characteristic to Interest. The key take away is that interest is an item that generates actual external flows in two directions and we are only interested in the net effect; therefore we add back Interest (1-tax rate) = Interest (outflow to creditors) – Interest*tax rate (inflow from the government) [Remember, this already happened before we arrived at the NI, so we are reversing the events that is why the signs are counterintuitive]. With Depreciation, just picture it in your mind as if you deposited (hid) the depreciation expense in another internal cash account. After computing your net income, we are asked to calculate the total cash available on the firm accounts. What you simply do is: you add the cash in all your accounts, i.e. Net income in your PnL Account + Depreciation Expense in your other internal account.
This explains why we add depreciation in full and only the after-tax interest is added.
Best and Good Luck in the CFA exam.