In calculating FCFF starting with either net income or CFO, why is the value of [interest expense x (t - tax rate)] added to net income to determine available cash? Maybe I’m just temporarily brain dead from studying too much today, but it seems counter intuitive to add an expense back to a cash calculation.
Is this simply the portion of interest paid on issued debt that receives preferential tax treatment? As in, net income already includes the full amount of interest expense removed, so we need to add back the portion that for tax purposes won’t reduce actual cash?
Technically, you should be adding back not interest expense (which could include some amortization of a bond premium or discount) but coupon payment (net of tax, of course), but CFA Institute won’t include that subtlety in their questions on FCFF.
I am confused about the Interest Expense (IE) and Interest Payment (IP), my questions are as follows :
Is that the IE on Income Statement actually the the IP ?
What are the IEs in bonds and leases (as in Reading 32) ? Is the total amount of the IEs or the IPs is indicated on the Income Statement collectively as an IE ?
For a bond, interest expense on the income statement includes the coupon payment and the amortization of any premium or discount on the bond. If the bond were issued at a premium, it has a built-in gain that is amortized over the life of the bond; that amortized gain reduces the interest expense, so the expense shown on the income statement is less than the coupon payment. If the bond were issued at a discount , it has a built-in loss that increases the interest expense, so the expense shown on the income statement is more than the coupon payment.
Interest expense on the income statement includes interest paid on bonds and on finance leases. The interest expense on a finance lease is less than the total lease payment, because the payment includes some principle as well.
As long as FCFF is calculated using the indirect method (starting from Net Income and doing adjustments), then you should add back interest expense, not just interest payment. Because NI contains interest expense after tax, therefore that’s the adjustment you must make.