Interest Expense and A/P effect on FCFF and FCFE


I know this question was previously posted and answered here before but I still cannot seem to understand the logic. I am having trouble in particular with the effect of Interest expense and A/P on FCF. Can someone please explain to me step by step on how to arrive at the answers? Thank you. “Indicate the effect on this period’s FCFF and FCFE of a change in each of the items listed here. Assume a $100 increase in each case and a 40 % tax rate” D) Interest Expense I) Notes Payable Answers: D) FCFF 0 FCFE -60 I) FCFF 0 FCFE +100

Are you sure your answers are correct? A change in accounts payable would definitely affect FCFF.

The logic is straightforward. The interest payments are payments to the debt holders. So, it will impact only FCFE because FCFE is calculated by subtracting the interest payments from the FCFF. If some debt (principal) is also repaid, then that is further reduced from the FCFF because the total funds left for the equity holders will be reduced. If some debt is issued then that is added as there is not more cash flow available for distribution to the equity holders. Since interest payment is tax deductible, we will subtract Int*(1-T) = 60 from the FCFF to get FCFE. So, FCFE will be reduced by 60 and there will be no impact on FCFF.

When there is an increase in the accounts payable, it means that the company has excess cash now because if the accounts payables had not increased, the free cash flow to both the parties as (firm as well as equity holders) would have reduced. So, an increase in accounts payable will increase both FCFF and FCFE by 100 as mentioned by Steve.

Unless there is an error in the official curriculum answers, those are indeed the EOC solutions.

I’m with Steve and aj on the FCFF AP.

Hi for the increase in payable effect consider the below approach:

Assume that a trading company has only cash transaction and no non cash expenses like depreciation or amortization and no loans no opening or closing inventory… Such that the profit earned by the company equals the cashflow during the period… I.e cashflow statement starts at net profit and there will be no adjustment…

In the next year company purchases goods on credit and got a closing accounts payable balance of $ 100 in that year ( i.e. saved $100 temporarily in that year)…

What will happen to the cashflow and profit… Will they still be equal? No! CF ( be it fcff or fcfe) will be more by 100

Net profit assume $10000

Only Adjustemnt : increase in payable 100

Cashflow : 10100

Hope it helps :slight_smile:

Sorry, my mistake guys - you are right that FCFF +100 FCFE +100 for an increase in A/P. I meant to copy Notes Payable , which the answer to is FCFF 0 FCFE +100. My apologies.

Can someone please explain why the FCFF does not change but FCFE increases by 100? I am confused because WCinv excludes notes payables.

Notes payable is a short term interest bearing liability considered as part of debt capital. Increase in notes payable is similar to increase in net borrowing meaning that more cash is available for equity providers.

There. That’s better.

S2000magician… You are indeed a Cheetah of Financial analysis. Are you a tutor as well?

I am.

I am confused about the depreciation part. If depreciation increases by $100 then why FCFF increases by only $40 (in this example tax rate is 40%). Why we are not adding back “depreciation*(1- tax rate)” which is $60.

Thanks in advance

Depreciation itself has no effect in cash flows because it is non-cash. The only effect it has on cash flows is by indirectly affecting taxes to be paid, which are cash out.

If depreciation increases by 100, then the taxable income has decreased by 100. This means you pay less taxes by 40, thus 40 more FCFF.

Note that this reasoning is true as long as you have calculated FCFF using indirect method of cash flow: starting from NI or above and adjusting accounts by non-cash movements and WK variations.

Hope this helps.