FCFF

[Znieh15]

FCFF = CFO + [Int x (1-tax rate)] – FCInv

Can someone explain the interest section to me. I understand that FCFF includes cash to debt and equity holders so you add the interest expense back for debt holders…but why do you multiply it by (1-tax rate).

I guess it’s because the amount you pay in taxes goes out the window, so you are only really looking at the part directly paid to creditors? If that is the case, this is going to be a really dumb question, but why do you pay taxes on interest you pay to creditors?

[S2000magician]

@Znieh15

FCFF = CFO + [Int x (1-tax rate)] – FCInv

Can someone explain the interest section to me. I understand that FCFF includes cash to debt and equity holders so you add the interest expense back for debt holders…but why do you multiply it by (1-tax rate).

I guess it’s because the amount you pay in taxes goes out the window, so you are only really looking at the part directly paid to creditors?

No.

The reason is that the government loves you, and wants you to use debt financing, and when you do they pay part of your interest expense (in the form of a tax subsidy: your taxes are reduced when you pay interest).

If you paid $100 in interest, and your marginal tax rate were 40%, then your taxes were lower by $40, so the net cash outflow is -$100 + $40 = -$60; that’s the amount you add back to CFO.

[Znieh15]

S2000Magician, you are starting to become my best friend–really appreciate the responses.

How exactly does that work–say I borrowed $10,000 at 10% interest over 10 years. My interest expense is $1,000 in year 1. The government tax rate is 40%. So they tax all my other income at 40%, but give me a $400 break here for using debt?

[S2000magician]

@Znieh15

S2000Magician, you are starting to become my best friend–really appreciate the responses

In that case, please remember me in your will.

@Znieh15

How exactly does that work–say I borrowed $10,000 at 10% interest over 10 years. My interest expense is $1,000 in year 1. The government tax rate is 40%. So they tax all my other income at 40%, but give me a $400 break here for using debt?

Exactly!

If your other income were $5,000, you’d pay $2,000 in taxes. With the $1,000 interest deduction, your taxable income is only $4,000 (= $5,000 – $1,000), so you pay only $1,600 in taxes; you’re $400 better off.

[TheLakeHouse]

We don’t need to adjust for interest expenses if we follow IFRS, right?

And under IFRS if we classify dividend paid as CFO instead of CFF, we should add dividend paid back when calculating FCFF??

[S2000magician]

@TheLakeHouse

We don’t need to adjust for interest expenses if we follow IFRS, right?

And under IFRS if we classify dividend paid as CFO instead of CFF, we should add dividend paid back when calculating FCFF??

I’ve never seen CFA Institute make that distinction. I suggest that you don’t carry it further than the formula given at the top.

[TheLakeHouse]

Hi , I don’t remember exactly but it might be somewhere in the curriculum.

My reasonings are:

1. under IFRS, interest paid can be classified CFO or CFF. So, if it has been placed in CFF, there’s no need to adjust CFO.

2. Also, under IFRS if a company has included interests and dividend received in CFI instead of CFO, the company should add them back to CFO to determine FCFF

3. Under IFRS, dividend paid can be classified as CFO or CFF. If dividend paid is included in CFF, they should be added back to CFO to determine FCFF

Anyway, I agree with you that I should not make things more complicated :(. There’s a wierd “phenominon” for me these days that is the more I study, the more wrong answers I hit because I seem to mess simple things up. Thanks

[S2000magician]

I understood your reasoning. You understand my viewpoint. Cool!