Schweser SS# 12, Page# 191 says, FCFF=[EBIT*(1-tax rate)]+Depreciation-FCInv-WCInv What happened to interest tax shield? The firm is not paying tax for the interest expense. I think the right formula should be the one below. Please correct me If my understanding is not correct. FCFF=[EBIT*(1-tax rate)]+Depreciation-FCInv-WCInv +(Interest*Tax rate)
You are wrong. Use Schweser formula as stated. Interest is tax deductible and is reflected in the equation.
Look at it starting from basics: FCFF=NI+Depr+Int(1-T)-FCinv-WCInv Now NI = (EBIT-Int)*(1-T) Substituting and linking terms - you see the Int(1-T) cancels out and you are left with EBIT(1-T)+Depr - FCInv - WCInv.
You need to know that when you are calculating cash flow for the firm (FCFF), then Interest is not taken in the picture AT ALL. Not the Interest Expense and NOT even the Tax Shield on Interest Expense. It is like you dont care if the firm has any or how much debt. For FCFF, Capital Structure is totally redundant. Now, not including Interest Expense in FCFF is obvious to you, right? But why not the tax shield on that Interest Expense? This is because you are discounting FCFF by WACC, which already has ‘after tax cost of debt’ in it. So, including tax shield on interest in FCFF would mean you are increasing your FCFF by that amount and then discounting it later with a lower rate (WACC, which has been lowered by tax shield on interest expense already). That would be double counting your tax shield on interest expense. Do you see it?