This is from the CFA end of chapter questions. Indicate the effect on FCFF and FCFE, assuming a $100 increase in Interest Expense and a 40% tax rate.

FCFF= CFO+int(1-t)-FCINv so FCFF increases by 60 while FCFE =FCFF-int(1-t)+net borrowing so this is unchanged. Hope this helps

Int expense doesn’t affect FCFE but FCFF will be increased by 100(.6)=$60. The formula is Net Income+non-cash charges +int expense(1-tax rate)-capex-working cap

FCFF increase by the change in int(1-t) FCFE decrease by the change in int(1-t)

whoops, just saw the other’s post. yeah, FCFE stays the same.

thats what i thought. But interestingly the answer at the back of the book (Volume 4 A-33) says Change in FCFF=0 Change in FCFE=-60

uhm no …

pimpineasy Wrote: ------------------------------------------------------- > uhm no … its reading 42 question 1D on the cfa curriculum volume 4 p403.

they prolly switched the top and bottom dollar amounts. check the errata page.

why doesnt interest expense affect FCFE ? Is it because the [-int(1-t) + net borrowing] cancel out when you increase interest expense ?

the curriculum is correct. when you start with NI - you already have 60 removed due to int. expense in NI - then you add it back to calculate FCFF - so 0 is your answer for FCFF. FCFE - from FCFF you remove 60 - so -60.

makes sense.

cpk123 Wrote: ------------------------------------------------------- > the curriculum is correct. > > when you start with NI - you already have 60 > removed due to int. expense in NI - then you add > it back to calculate FCFF - so 0 is your answer > for FCFF. > > FCFE - from FCFF you remove 60 - so -60. but this wouldnt work if I follow the CFO - FCInv + Int(1-t) ?

It definitely would. remember CFO does not happen by itself. Indirect method for CFO - starting point is NI - where you already have Interest expense removed once.

I didn’t even use any quant to solve this, but here was my thought process: If interest expense increases, why would the bondholders care? They are being paid interest. The equity holders would more like care since that extra interest expense would be less cash to them. It wouldn’t be the full amount, though, since the government subsidizes a part of the interest cost due to the tax shield on the cost of debt.