Probably an easy question… The formula for FCFF is: FCFF = NI + NCC + Int(1 - TR) - FCInv - WCInv Let’s also assume that depreciation is the only NCC. Why is interest expense added back on an after-tax basis but depreciation is not? Net income includes the after-tax effects of both interest expense and depreciation expense, but only interest expense is adjusted in the above equation. What am I missing?
entire depreciation is being added back as part of NCC… so what are you missing?
And that was my original question. Why is ALL of depreciation added back, but interest expense is added back on an after-tax basis? Both reduce earnings producing tax effects, but they are treated differently when calculating FCFF…
This is very similar to the CFO calculation. You add entire Depreciation back there as well… because it is a non-cash expense.
The reasoning behind adding back Depr. is simple, its a non-cash expense. The reasoning behind Int(1-T) is a little more complex. FCFF is basically “unlevered cash flow”, i.e. we recalculate cash flows assuming NO debt in the capital structure. Example: EBIT = 100 Int. = 10 Tax = 30% Net Inc = (100 - 10)*(1-0.3) = 63 If we assume there was zero debt, Net Inc. = 100*(1-0.3) = 70 This is equivalent to adding back Int*(1-T)…10(1-0.3) = 7
nirjraina, thanks for the example. Mathematically, everything makes sense, but the logic behind it was confusing me. After thinking it through, I think get it now. Implicit in Net Income is [-Dep*(1 - TR)] and [-Int*(1 - TR)]. Adding back the full Dep leaves just the tax benefit as part of FCFF (i.e. Dep*TR). Since FCFF is an “unlevered cash flow,” as you described it, then we need to add back both the interest expense AND the associated tax benefit. This is accomplished by adding back Int*(1 - TR). If we add back the full Int like we do Dep, then this would assume we still get the tax benefit despite the assumption of no debt in the capital structure. Please correct me if my logic is wrong. Thanks.
You have it 100% right