FCFF/FCFE question

CFA Level II Equities
#1

When there is a $100 increase to Interest expense, when taxes are are 40%…

How come FCFF is not affected? and FCFE is -60?

I had first thought FCFF would go up, since +interest expense (1-taxes)… Does something else in the equation balance it out? And for FCFE… its -60, because more interest is paid to bondholders, so less free cash flow for equity owners… makes sense.

Also for depreciation is increased by $100, with a tax rate of 40%… Both FCFF and FCFE is increased by 40… I had first thought htat it was just up 100, since you add Noncash charges… but this has to do with the tax shield right? When you do EBITDA… you need to add Depreciation (Tax). Can someone explain this depcreaiton?

Also - this question did not provide financial statements (or i would have just calculated these)…

Thanks!

#2

Which question is this?

#3

Equity book - page 345.

#4

Yes: net income.

#5

I was amazed to many wrong in the same question. Apparently by just plugging in the FCFF and FCFE formulae these don’t seem right. Could someone who understood this throw some light here. Thank you.

#6

Remember FCFF is not affected by funding costs.

#7

Lets say

NI = 150

Interest = 25 (included above)

T = 30% (included above)

FCFF = 150 + (25*.7) = 167.50

+100 to interest expense

New NI = (150 - (100*.7) = 80

New interest = 125

T = 30% (reflected in NI)

NEW FCFF = 80 + (125*.7) = 167.5

#8

in other words Interst expense is added back to get FCF…

FCF will reduce due to increase in Interest expense

#9

Interest net of taxes is removed as part of net income, then added back to get FCFE FCFF; the net effect is zero.

#10

You mean FCFF?

#11

the increase doesnt affect FCFF as it is the Free Cash Flow to the Firm … before any payment made to the bondholders/debt

any payment of interest shall reduce FCFE … that is also one of the reason why Interest(1-t) is added back to get FCFF …

#12

Good catch.

Fixed it.