After tax interest addition to FCFF

CFA Level II Equities
#1

While calculating FCFF we add back after tax interest to it ( + int(1-t) ). By definition FCFF is the cash available to providers of the capital i.e equity holders and bond holders. So, shouldn’t we add back the whole interest to FCFF? Why don’t we include the benefit of tax saving due to interest in FCFF calculation?

(Eg: Let’s say there’s an owner, an equity holder, a bond holder, and a tax official standing side by side. The owner now distributes money to each of these in the following manner.

EBIT =100 ,

interest = 10 ( to bondholder)

tax (40%)= (100-10)* 0.4 = 36 ( to tax official)

NI = 100-10-36= 54 ( to equity holder)

So shouldn’t FCFF = 54 + 10= 64

I understand that there is a benefit of 4 in tax saving due to interest payment, and that benefit is include in NI. But still, in the end the owner is paying 36 ( and not 40, as would have been the case if the interest was not deducted) to the tax official and 10 to the bondholder. And now when I calculate ‘actual’ cash flow to the equity and bondholder, it comes out to be 64 and not 60.

#2

Not sure that I fully understand the question… We can’t include the full interest amount in FCFF as we still need to pay the required tax amount - given this is an obligation it’s not cash that is available to the firm.

Your calculations are a little confusing to me I’m sorry. Not quite sure where the figures are coming from but for example your tax calculation of (100-90) * 0.4 should equal 4, not 36.

Sorry if that doesn’t help.

#3

I’m sorry it should have been (100-10) *0.4. I have corrected it. My question is that actual tax payment is 36, so why the saving of 4 in tax is not included in FCFF.

#4

Fcf is cash avb to providers of capital, debt and equity, so EBIT net of tax is available capital, in your example EBIT is 100, tax rate is 40, available cash 100- 40 = 60.

Hope this clarifies.