Study Session 12, Reading 41. The formula is FCFF = NI + Dep + Int(1-t) - FCInv - WCInv In computing FCFF, why do you add back the full value of depreciation expense and not the after-tax value (like interest expense)? Thank you for your help.
its 1) non-cash 2) if acquired, the mgt can change depreciation and affect taxes, at least my opinion
That’s how I see it too.
I’m not good at accounting, but I think it’s because interest expense is actually paid out to bondholders whereas depreciation doesn’t actually require cash moving out of the company’s hands.
Because depreciation has already tax sheltered your income (you deducted it already in determining NI), and the remaining amount is entirely non-cash.
Just imagine if you own the whole firm and do not have any bonds then you would pay tax for the interest. That is the reason you only save 70% of the interest and not in the case of depreciation.
I pay interest of $10 million. Assuming a 30% tax rate, i reduced my taxes by $3 million (for a net cash interest expense of $7 million). Therefore, i add back my net interest expense ($7 million) to get to FCFF I record depreciation of $100 million, which reduces my taxes by $30 million. I must add back the entire $100 million, because it was a non cash expense, and I’m trying to arrive at a cash number.
when you get NI, you deduct the full amount of Dep. so you have to add full amount of Dep. don have to consider the tax.
I actually have this same issue and have talked to others at my firm about it. Depr DOES provide a tax shield. Even if it’s not actual cash, the tax saving IS a real cash saving. It’s the same thing as with interest as you deduct both before you get to your NI. The only rationale I can offer is that the actual cash implications of depr are different from interest as the ACTUAL tax saving isn’t what is reported. This is because tax authorities allow depr at a different rate from how the firm accounts for it giving rise to DTA’s and DTL’s. Any clarity on this because I’m in the same boat as the OP and don’t get the differing treatment here.
Unliever is right, unlike interest, depreciation is subject to different rates for tax and accouting purposes. If depreciation for both tax and accouting purposes is the same, the tax benefit is already built into Net Income. Otherwise, the difference is recognized by working capital adjustments (increases/decreases to DTA or DTL).
Depreciation is added back because it is a non-cash charge. So to get a cash charge you add it to Net Income. In Interest expense case, it is a cash charge (all of it) so there is a tax shelter you have to take care of.
For Depreciation, i will repeat what eighty and other said. ‘It is added back because it is non-cash charge’. For Interest: 1. FCFF is Cash Flow to firm before it is distributed to Debt or Stock holders. 2. For FCFF calculation, you should assume, there are NO Debt holders to be paid, i.e. Interest Expense is not to be considered AT ALL. 3. Now, how much effect of Interest Expense is already there in NI? Answer: NI got reduced by I(1-t) because of the Interest effect, right? 4. So, simply add back I(1-t) to NI, to simulate as if firm does not have any bond/debt holders and does not pay any Interest.
also another way to think about it… differing companies may have different levels of debt / different interest payments. if you add back the After-tax interest to the calculation - it becomes more comparable across companies.