FCFF/FCFE, intuitively

When solving for FCFF/FCFE why are we adding back ‘Int (1 - tax rate)’ and ‘net borrowing’ respectively? Tax shield, money available to equity holders, etc. Understand the fixed capital, working capital investment aspect, but the debt part is not sinking in. It’s going to be difficult to memorize all the different derivations so need to get better understanding of what’s really happening. Thanks, John

In the case of FCFE you want the cash flow that is available to pay your equity holders… the interest rate that you pay on debt is not avilable to pay your debt holders, because that goes to your debt holders. on the other hand the new borrowing, ie money you get from issuing new bonds, well you are free to give that you your equity holders… thus interest is not added back to net income in the case of FCFE but new borrwing is added in the case of FCFF you want to add that interest back to your net income because you are looking for cash available to pay all your providers of capital, and it makes no sense to pay your debt holders interest and then say the amount left is what is avilable, what is available to be paid is the amound before you paid the interest, the interest was just a choice you made to pay some of that available cash… you do not add the new borrowing to FCFF because it is money comming in from debt holders, and since FCFF is cash available to pay everyone, it makes no sense to say you are getting cash from your debt holders, and now it is available to pay your debt holders… -------------- i hope that helped, and if you understand there relationships you will not have to memorise a single FCFE or FCFF formula, you can use logic to arrive at it from anything

Also, int (1-t) is used because of the tax shield. If there were no taxes or no deduction of int you would just add back int. But since int is tax deductible, the cash available to the equity holders is increased by the amount of taxes you don’t have to pay (the tax shield)

^ i think Thecodont did okay , but I am gona try to detail it more to get to FCFF you from NI, you add back interest(1-t) the reason you do not add back the full interest is because, assuming you do not pay interest, you will lose that tax shelter that resulted from having paid interest, and you will pay more taxes, you extra taxes will be = to intrest*t so by adding back interest(1-t) esentially you are adding back (interest) then subtracting interest(t) this tax shelter is not actually lost, because you are still going to have to pay interest, it is just that it will be accounted for in the (1-t) in the WACC