Level II people; I know its very basic question for you but pl.explain… When we are deriving FCFF from NI we add back entire depreciation amount to NI but only (1-tr)Interest amount? Why do we not add back entire Interest amount if both the deductions are pre tax ?
because depreciation is a non-cash item Best, TheChad
Don’t remember much but let me take a shot. we add dep because it is non cash transaction. Tax is cash transaction.
Thanx But let me take an example to make my point.I hope this example does not add to the confusion 
… Lets say EBITDA is 5000 Case 1) If we consider that there is no Depreciation and Interest charges.And tax rate is 30% then after tax cash flow will be 5000(1-0.3) = 3500 and total taxes paid = 1500$ Depreciation and Interest paid bring in tax related benefits… Case 2) Now let say Dep = 1000$ and interest paid is 500$ Then NI = 5000-1000-500-taxes = 2450 and taxes paid = 1050 But from FCFF point of view 1000 and 500 were never paid (interest was paid but it is still with the firm’s stake holders) So the actual cash available to stake holders (in my opinion) = 2450 +1000+500 = 3950$ There is tax related saving of 450$ by having tax deductible items worth 1500 (450 is difference in the taxes paid in case 1 and 2) Now to get this value from NI (2450$) should be 2450+1000+500 = 3950$ but based on the formula is should be NI+ Dep+(1-TR) Interest . Not sure where I am missing the conceptual difference between Dep and Interest paid.
What do you mean level 2 people?
hey By level II I mean people who appeared or are preparing for it .Since it is from L2 curriculum… I hope no one is offended by it…Question is open to any one … Thanks
Haha. I’m wasnt offended by your question. I was making a refernce to the movie Tropic Thunder.
AJ8888 Wrote: ------------------------------------------------------- > Thanx > But let me take an example to make my point.I hope > this example does not add to the confusion > … > > Lets say EBITDA is 5000 \> \> Case 1) If we consider that there is no \> Depreciation and Interest charges.And tax rate is \> 30% then after tax cash flow will be 5000(1-0.3) = \> 3500 and total taxes paid = 1500$ > > Depreciation and Interest paid bring in tax > related benefits… > Case 2) Now let say Dep = 1000$ and interest paid > is 500$ > Then NI = 5000-1000-500-taxes = 2450 and taxes \> paid = 1050 > But from FCFF point of view 1000 and 500 were > never paid (interest was paid but it is still with > the firm’s stake holders) > So the actual cash available to stake holders (in > my opinion) = 2450 +1000+500 = 3950$ > There is tax related saving of 450$ by having tax > deductible items worth 1500 (450 \> is difference in the taxes paid in case 1 and > 2) > > Now to get this value from NI (2450$) should be > 2450+1000+500 = 3950$ but based on the formula is > should be NI+ Dep+(1-TR) Interest . > > Not sure where I am missing the conceptual > difference between Dep and Interest paid. People always have trouble with concept and I am one of them. If I actually remember, there is an important point in balancing WACC after-tax interest costs to your FCFF after-tax interest costs for some sort of conformity.
The formula for FCFF is; NI+Dep-WcINv-FcInv+Int(1-T) You add back interest since it is a cash flow to debt holders. The reason you take (1-T) is that the actual cash expense is less than the nominal amount since it lowers the tax burden. Depreciation on the other hand isn’t a cash flow, it is just a non-cash expense so you add back the whole thing. think through the formulas
But net income is reduced by the full amount of the interest, and so part of the interest expense is non-cash, so it almost seems that portion should be added back as well (just like depreciation).
I agree with TheAliMan.I am confused on this so if someone can enlighten?..
We all agree (I hope) that depreciation is added back in full afterwards since it is non-cash. Remember that NI still keeps the benefit of the tax shield from depreciation. Now, FCFF is all cash flows available to debt and equity financing. Therefore, we want to add back the interest expense to net income, but we need to realize that there is a tax shield from interest expense built into NI. If we add back all of the interest expense, we would still be keeping the tax shield (just like depreciation). Since FCFF should not depend on capital structure, we do not want a tax shield from interest. Therefore, we only add back the after tax portion of the interest expense. This way, we have entirely negated the interest expense and not kept the tax shield. So basically we have a cash interest expense (-x), a tax shied (+x*t), and the after tax portion of interest (+x*(1-t)). Summing these three we get -x+(x*t)+x*(1-t)= -x+xt+x-xt = 0.
There are two things to keep in mind here. FCFF is a Cash Flow, but Net Income is a economic accounting estimate of value. Also Net Income is referring to the economic impact to equity owners, while FCFF is referring to cash going to both debt holders and owners. If a company has $5000 net income, it doesn’t mean that they made $5000 in cash last year. It means the approximate economic effect of last years operations is 5K. To convert this economic equivalent number (called net income) to an actual amount of cash available to both debt and equity providers, you have to add back non cash items (dep.) because they do have an economic cost (your machines get older) but no cash changes hands (you don’t have to replace the old machines yet). Also, since FCFF is telling us how much cash was available to debt and equity holders BEFORE we paid either of them (interest to debt & dividends to equity), we need to add back interest. The reason is that Net Income already has interest deducted. So we add back interest, but not all of it. The reason is that we would have owed more taxes had we not paid interest.
Thanks to both dlpicket and kaklan…but if you can, please go thru my hypothetical example and explain what true FCFF will be.Note: I have taken 5000$ as EBITDA (not NI) which in my opinion is cash available to stake holders before taxes (assuming no depreciation and interest ) The confusion i have is from FCFF point of view there should be same treatment given to both depreciation and interest paid (As both have tax advantage and from FCFF point of view interest is kind of non cash since cash paid is still with stake holders) Here are the quotes from Stowe’s notes to add to more confusion (atleast for me). It says: After-tax interest expense must be added back to net income to arrive at FCFF. This step is required because interest expense net of the related tax savings (??)was deducted in arriving at net income, and because interest is a cash flow available to one of the company’s capital providers. What do we mean by "interest expense net of the related tax savings " ? We deduct entire interest paid to get NI. Please clarify…
- Interest expense gives you tax savings. So full interest expense is not added back. The Interest expense Net of Tax savings I*(1-T) is what is added back. Tax savings due to Interest paid = I * T 2. Depreciation is NON Cash. So it is fully added back. (EBITDA - Depr - Int) * (1-T) = NI And FCFF = NI + Depr + I(1-T) - FCInv - WCInv So plugging back FCFF = (EBITDA - Depr - I)*(1-T) + Depr - FCInv - WCInv = EBITDA(1-T) + Depr * T - FCInv - WCInv
AJ, in your example, you are calculating after tax cash flow, which is not the same thing as FCFF. Think of FCFF as cash that can be divided between debt holders and equity holders BEFORE paying interest/dividends and BEFORE paying taxes (since the amount of interest paid will help determine tax). The reason you add back depreciation in full is because you’re still going to claim it on your taxes, but it doesn’t represent an actual cash flow. Interest can’t be added back in full, because if you are retaining the cash at the firm, you’re going to have lower interest expense, hence higher tax.
cpk123, glad to see you back here. How have you been?
Ali I have been fine, work keeping me busy and without any studying do not know what to do!!! Hope there is a PASS at the end of the tunnel which is still 4 weeks long!
The FCFF calculated in the second case is wrong. Consider the following. FCFF is the cash flow available to the firm if no interest was paid. Calculating from EBITDA of 5000… It is 5000-1200 (tax paid with no interest) = 3800. FCFF is not the actual cash flow but an amount available to the firm’s stakeholders. Now 3800 is the amount available to the stakeholders, and they decide to pay 500 as interest. 350 is the actual outflow from 3800 as they saved 150 from taxes. Let the last sentence not confuse you here. Hope this helps.
AJ, please have a look at pg 198 of the CFA 2012 equity book -the first paragraph and under note 5. The reason interest in after tax is because the WAAC has a debt component which is after tax. You could add it back before tax, just like your depreciation but then your WAAC must not include any tax shields on debt. Either way, you’ll get the same answer! The key is consitency.
To all those whom don’t trully understand, and I’m not trying to be concieted or above you, I hope this helps you too.