Need help on FCFF!!!

CFA Level II FRA
#1

Hello, everyone

I am very confused with FCFF concept. The book said the FCFF=CFO+Int(1-tax)+CFI. It means the cash flow before debtor and creditor. Here is the part I am confuse.

What if the Interest is caused by a discounted bond? Let’s make a example. A Co. has a revenue of 100( all cash) this year with no other expense, but there is a discounted bond outstanding. The tax rate is 20%.The entry related to the bond is below:

Interest Expense……15

Discount on bond payable……5

cash……10

so Net income before tax is 100-15=85 Tax is 85*20%=17 Net Income is 85-17=68

So what is the FCFF? I have two thoughts in my mind, but i don’t know which one is right? or both of them are wrong

  1. Since the FCFF is measure the free cash before debitor and creditor, the FCFF is 100 (cash received) - 20(tax)=80. Because if there is no interest expense the income before tax is 100. The tax is 20.

2.According to FCFF=CFO+Int(1-tax)+CFI. CFO=68+5=73. Now i am not sure Int(1-Tax) part. we use 10 as Int or 15 as Int? I think 10 is right. Because 10 is the real money we will pay to the debitor. then Int(1-tax)=8. The FCFF=73+8=81

This is $1 gap. I am so confused.

Thanks for the help!!!

#2

The way i think about FCF

Firstly Debtors would be the customers the company sells to and Creditors would be the suppliers the company buys from. These are not suppliers of capital and nor is FCFF a measure of free cash before debtors and creditors. Suppliers of Capital are Common Equity, Pref. Equity and Bondholders and FCFF is the cash available to these suppliers after expenses.

Secondly, i thnk FCFF will be $85

#3

On the exam they won’t give you any problems with diccount (or premium) bonds for which interest expense differs from coupons paid.

Don’t worry about it.

#4

Thanks for the reply. I am not worried about the question on the exam. I just clear my mind and know what is going on here.

#5

The interest in the formula should be, in fact, the coupons paid (the actual cash flow) net of taxes on interest paid.

#6

Thanks for the reply. You mean the second way I thought is right? Then what is wrong with my first one?

#7

CFO = $73

Cash interest paid = $10

Taxes saved on interest: $3

FCFF = $73 + $10 − $3 = $80.

#8

Thanks. Now I understand you way to calculate. Is the format FCFF=CFO+Int(1-tax)+CFI is not suitable for discounted bond or premium bond?

#9

You’re welcome.

That’s correct: it’s not.

#10

Thanks so much !!!

#11

My pleasure.