Reading 36 CFAI Practive Problem 1 [Equity Free Cash Flow Valuation (FCFF, FCFE)]

CFA Level II
#1

Paraphrasing the question “Indicate the effect on FCFF and FCFE if each of the following is increased by $100, assume 40% tax rate:” … Was confused by the solution to C, which is that if depreciation is increased by $100, both FCFF, and FCFE are increased by +$40. So thinking in terms of Sales-> EBIT-> Interest-> EBT-> Taxes-> Net Income, then an increase in depr of $100 would mean EBIT is lowered by $100, which means net income is lowered by 100(1-.4)= $60. Then adding back deprecation of $100 for the FCFF formula you get a net positive of $40. Is that logic correct?

(Similar question here about interest being subtracted) http://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91319014

#2

Yes, that’s correct.

To add to that, depreciation acts as a tax shield, which means that it lowers EBIT and therefore you have to pay less taxes. Since depreciation is a non-cash charge (NCC), you add it back (and minus fixed investment and NWC) to get FCFF.