Reading 35, EOC 1

Unnervingly, I’m struggling with what I think is a fairly basic concept in reading 35.

EOC question #1 asks the effect on FCFF and FCFE of a $100 increase in a long list of items. Most make sense but there’s one that I’m really struggling with. Specifically, for a $100 increase in interest expense, the solution says that this has no effect on FCFF and decreases FCFE by $60 (assuming a 40% tax rate). Why wouldn’t this increase FCFF by the $60 after-tax amount?

The answer key seems (to me) to fly in the face of the basic FCFF equation in cases where interest expense has been subtracted or never included to begin with. If we add it back to NI if it’s deducted in arriving at same, why wouldn’t we add it to the extent it was never included (which would be the case where we have a $100 increase) - these are the same, no?

I’m sure it’s me who’s being an idiot here, but any help would be very much appreciated.

can’t totally follow your second paragraph, but it kind of says the answer, no?

Ignoring R35 for a second, basic principles say a $100 interest expense will reduce net income by $100(1-.4) = $60, right?

Next, looking at FCFE, your $60 after-tax interest money is gone out the window to lenders. It’s not freely available to equity shareholders. So FCFE is $60 lower if interest rises by $100.

FCFF, on the other hand, is just a measure of cash that could theoretically be distributed to lenders OR equity shareholders. it doesn’t care – it’s equal opportunity free cash flow. if the company decided to go to zero debt and all equity financing, the amount of FCFF $$ shouldn’t change. who would get the cash would be different (lenders vs shareholders), but FCFF doesn’t judge. It’s just the measure of what can be distributed under cany capital structure. While we don’t have to start with net income, if we do, we know net income is $100(1-0.4) lower as a result of interest paid out. That’s not in line with the definition of FCFF – it needs to show that interest figure as being ready for distribution to anybody. So, we need to add it back in. If you take it out, then add it back in, it has no effect.

Yep - that clears it up - excellent explanation.

Thanks so much for taking the time to explain something to me that you cleary grasp very well - it’s much appreciated.

Paying interest to lenders is a use of FCFF; it doesn’t decrease FCFF.