Study Session 12 - Reading 40 Clarification

CFA Level II Equities
#1

Hello,

Can someone please clarify this for me?

EOC question 1: If depreciation increases by 100 why does FCFF increase by only 40? If there are two formulas for FCFF involving depreciation how do we know which to use when?

  1. FCFF = EBIT(1-t) + D-FCINv-WCINV

  2. FCFF = EBITDA (1-t) + Dt - FCINV - WCINV

Same thing for Interest increasing by 100 but FCFE decreasing by 60 and FCFF not being affected?

  1. FCFF = NI+NCC+I(1-t) - FCINV- WCINV

It is my impression that FCFF formula can be manipulated to get FCFE and vice versa but that is not always the case?

Thank you.

#2

Both depreciation and interest are tax deductible, so you capture the tax benefit associated with both in arriving at FCFE. That benefit is equal to the amount times the tax rate. Interest doesn’t affect FCFF, only FCFE.

#3

It’s still not clear to me. For example if interest doesn’t affect FCFF then why is it included in the formula for FCFF?

Also when calculating FCFF using the formula below depreciation (NCC) before tax is included and not only the tax benefit.

FCFF = NI + NCC + I(1-t) - FCINV - WCINV

Given all the information in a question how do you know which is the best formula to use since I don’t seem to get the same answers when I use different formulas.

#4

For simplication, let us assuming that Company A has cost only Depreciation.

So FCFF= (Sale - Dep)*(1-t) + Dep = Sale*(1-t) + t*Dep

If Dep increase 100 =>> FCFF up t*100 (if t=40%, FCFF up 40)

#5

  1. Depreciation increases by 100, FCFF (and FCFE) would go up by 40 (Dep X tax rate). That also makes intuitive sense, cash flow would increase by tax savings. This is so increase in depreciation affects NI (lower by Dep (1-T). And then you are adding back the entire dep in the formula - so net effect is Dep x T.

  2. Interest - no impact for FCFF NI decreases by Int (1-T) and we are adding back identical amount for FCFF. However FCFE would decrease by Int(1-t) as we are not it back.