I can’t understand why we add back interest(1-tx) to FCFF. I understand its the cash available to all, including debt holders. But why dont we just add back interest exp, instead of interest exp (1-tx), by us doing that we are incorporating the fact that it has been paid out and we received tax saving from paying it out, But if this is cash flow available to all, then we should NOT be assuming that its paid out.
many threads about this one, if you cared to search. Look at what goes into Net Income… to get to that number, and why you add back will then be clear.
The Interest expense gives a tax shield, as you already know. FCFF is a measure of cash that’s available to all the stakeholders of a firm. Because tax has to be paid and is no way available to the firm, we subtract the value of tax shield provided by the Interest Expense.
Think about it this way: You are trying to arrive at the result of the following formula all the time if you are looking for FCFF EBIT * (1-TaxRate)
Government takes tax which is paid in Cash . cash out of the door to Gov is a reduction of cash available to the company stakeholders So ( 1-T ) is all you ( i.e Stakeholders ) are left with as a percentage of Taxes paid T .
Yes but deprec exp is also like a tax shield, cause it reduces our expense and our taxes. But when we add it back it , we dont add it back in net of tax, like we do interest exp.
Depreciation is a non-cash expense… you also have situations of depreciation on books (financial accounts) being different from the Tax books. so it is just added back, in full.
yes Im sure im asking a riduculous q, but I can’t get my head wrapped around this for some reason. But how are cash expenses and non cash expenses taxed differently? I know a cash outflow will be taxed as income on the firm level and income on the shareholder level, That the only difference that I can understand.
just go back and read the chapter again. there’s a good conceptual picture in schweser notes
Interest Expense (1-T) is added back in the calculation of FCFF because the debt financing reduced your taxable income which amounted to a tax savings of Interest Expense (T). Adding back Interest Expense alone would ignore the cash flow savings generated by the debt, which reduces the overall “cost of debt.” Depreciation is added back in full because it is a non-cash expense. You cannot add back Depreciation net of taxes because there was no cash flow payment of “depreciation.” The only cash flow related to depreciation expense would be the tax savings resulting from the reduction of taxable income, which are equal to Deprecation Expense x (T)…and you cannot add this back because it was never “subtracted.” You should see now that the two expenses are, in fact, not treated different. The cash flow benefit of both expenses (Dep. Exp. x (T) AND Int. Exp. x (T)) are reflected in the FCFF figure. Interest Expense x (1-T) is added back because it represents the portion of the interest expense cash outflow going to compensate debt holders. Finally, the non cash depreciation is added back.