FCFF - Interest Expense

I am somewhat confused and was looking for some clairity. When solving for FCFF, from EBIT, we start by taking EBIT x (1-t) and then add depreciation and subtract FCInv and WCInv. What I dont understand is why interest never comes into play. Since we have EBIT multiplied by 1-t, aren’t taxes higher than they should be, because interest expense would have reduced the tax bill? We see that when we start with EBITDA, we multiply by 1-t, and then have to add back (dep x tax) because deprection would have reduced the tax bill. I know this is probably a stupid question, but why not the same for interest expense? Thanks in advance.

Normally you would add interest (1-tax rate) back when starting with Net Income. This is the income tax expense deducted in arriving at net income. When you start with EBIT, you havent yet deducted that income tax expense (earnings BEFORE interest and taxes), so you dont need to add it back.

I believe the answer lies in the fact that when you take the factor (WACC) on the denominator to arrive at the valuation for the firm (whichever model you use - Discounted Cash flow, or FCFF or FCFE) the WACC includes the Debt rate in there. So since you have considered it on the denominator, it is excluded from the numerator.

Thank you for both answers. Cpk123, thanks, I think that is more along the lines of what I was looking for. WACC includes the after-tax cost of debt. That makes sense. Thanks.

I didnt think you used WACC in the denominator for FCFE - I thought we used reguired rate fo return ~k ??

The question is for free cash flow to the firm, not free cash flow to equity.

I was responsing to CPK123 “I believe the answer lies in the fact that when you take the factor (WACC) on the denominator to arrive at the valuation for the firm (whichever model you use - Discounted Cash flow, or FCFF or FCFE) the WACC includes the Debt rate in there. So since you have considered it on the denominator, it is excluded from the numerator.” My point being - the factor for FCFE is not WACC its required rate of return. Im circling back and working on this…be back to you in a min with my take…

the schweser books seem to harp on the fact that interest in this context is considered a “financing” cash flow to bondholders and FCFF represents cash flows available to investors before any financing cash flows- so choice of financial leverage is a financing decision that wouldn’t affect FCFF. thoughts?

Okay I think I figured it out. NI: 240 NCC: 300 Int (1-tax rate @ 40%) 60 FCInv (400) WCInv (45) FCFF = 155 with me? Now if you start with EBIT which equals 500 (NI +interest expense +taxes) EBIT (1-tax rate) 300 NCC 300 FCinv (400) WCinv (45) FCFF = 155 Same result. The question was asked…why do we not add “interest exp (1-tax rate)” like we do when we start from NI. EBIT is $500. After we multiply 1-tax rate of 40% we arrive at $300 The difference, being 200, is composed of $160 in taxes and $40 in interest expense. So of the $100 you have in pretax interest, you reducing by $40 due to the (1-tax rate) factor multiplied to EBIT, which leaves $60. This $60 is what you would have “added back” if you started with NI. But you dont need to add it back because its already in EBIT. If you added back “interest (1-tax rate)” you’d be adding $60 back However, instead of adding 60 back, you are starting with $100 (because EBIT is before the $100 in interest espense) and just taking 40 away. The end result is that you still have $60 in your calc. Im terrible at explaining…but thats the best I can do.

bueller…?

your #'s above look fine to me. i think staring at this thread has helped me to almost commit the FCFF formulas to memory now starting from either NI, EBIT, or EBITDA. moved on for now to easier things… P/E, P/B, P/CF ratios and the likes.

jbisback, just so I’m clear, EBIT(1-t)=NI+IntExp(1-t), right?

Yes indeedy…that is correct.

Just a side note. There are a lot of equations in that chapter for both FCFF and FCFE. I know this may seem obvious to some, but instead of trying to memorize all the equations, I simply start by trying to make adjustments to NI, EBIT, or EBITDA to arrive at CFO. If you’re given NI, no income statement adjustments are needed. If you’re given EBIT or EBITDA you have to adjust for the I (for FCFE), T and DA. Again, this may be obvious, but it will help you to memorize less.

jbisback Wrote: ------------------------------------------------------- > Yes indeedy…that is correct. Thanks. This actually cleared up a similar issue in CorpFinance.

I think for this to work however, the assumed effective tax rates have to remain the same for the FCFF calculation starting at EBIT or NI. This should always be the case unless somebody is calculating taxes under the current tiered federal corporate income tax system and different effective tax rates result from starting with EBIT vs. EBT. Also, things like non operating income and non operating expenses can affect tax paid if starting with net income.

In addition to the above…the only way this will work is if the world doesnt end tomorrow. cmon now…CFAI isnt going to get that cute.

jbisback, well said. sorry for getting carried away.

Sorry…was in a bad mood yesterday. Stuck in the office all night.