I can understand the free cash flow to the firm including interest income from investments into other companies and all … but why are interest epenses excluded out of free cash flow to the firm. Those are necessary expenses and have to be made and cant be used for firm for going concern so why include them as a part of FREE CASH FLOW TO THE FIRM ??
Interest expense is not excluded from FCFF.
What made you think that it is?
unlevered income is EBIT(1-t) isnt it to which the depreciation and capex adjustments are made … thats how fcff is calculated no???.. so they are considering Interest expense as something which can be used for firm but it cant be. missing something?
Sorry … stupid … wikipedia makes it quite clear. now i understand it. thanks for the reply though
My mistake: I misunderstood your question.
The money used to pay interest is available to the firm. The fact that they have to pay it in interest merely means that it’s not available to the equity holders, not that it’s not available to the firm. In that respect it’s similar to taxes: the money is available to the firm, but they have to pay their taxes with it.
Okay see … i just want it clear, please bear with me a little.
FCFF is the money available to the firm( equity holders and debt holders). So the transaction proceeds something like this. EBIT - Taxes(=EBT(1-t)) - Interest payments = net income, right?
Now that interest payment is available to debt holders only, it means that money is in the FCFF
So why are we adding back the AFTER TAX INTEREST to the income to calculate the FCFF. Shouldnt it be interest as a whole?? I mean tax is applicable only on the EBT and interest paid is tax exempt??
think of FCFF as the amount of cash the assets of the firm generate, before you consider how they are financed (with either equity or debt).
so basically, if these assets stood on their own ie. nobody owned them, they would generate x amount of money - this is the goal…
now in this case, of course you wouldn’t consider cash flows associated with debt financing - neither principal payments or interest payments.
also, remember that if there are no interest payments, there are also no interest tax shields we generate when we deduct interest expense from EBIT.
so when getting to FCFF, starting with net income, you must add back interest payments and also subtract interest tax shields, OR… just add back after tax interest payments.
See the motivation of calculating the FCFF is to value how well does the firm stand for payments to its equity holders and financing providers.
So taking the interest back is understandable. it is afterall a cash flow given to the financiers.
But removing their tax shield is, i think, inappropriate since that tax shield is there and will benefit the company. consider two different firms one entirely operating on financing and one entirely operating on equity raised capital. both generate same amount of EBIT. But equity one ends up with less money for security holders as they have to distribute more and financed company have interestXt more money for the security holders.
In corporate finance, free cash flow (FCF) is a way of looking at a business’s cash flow to see what is available for distribution among all the securities holders of a corporate entity. - wikipedia .
The money that is saved by tax shield is available for the distribution amongst the security holders. I am memorizing the thing as you are saying for the exam but i cant justify it to myself. Any explanation is appreciated if anyone can provide.
removing the tax shield is inappropriate for when you are calculating FCFE…
remember, FCFF is free cash flow of the assets, regardless of how they are financed. therefore when starting from net income, you need to remove every single trace of cash flows that have occured due solely to financing.
both interest payments and interest tax shields have occured SOLELY because we have financed the assets with debt.
therefore we need to remove them both!
not so for FCFE however… since, as you suggested the tax shields generated by the interest payments are cash flows available to be distributed to equity holders
Ohh … i guess i was mixing the two things. So FCFF measures the capacity of the firm to produce cash with a given amount of capital( irrespective of where it comes from).
Thanxx mate