FCFF and FCFE Effect of Interest Expense

CFA Level II Equities
#1

Hi everyone,

In Reading 31, EOC Question 1 we are supposed to identify the effect of a $100 increase in interest expense on FCFF and FCFE (tax rate 40%)

The solution states that FCFE decreases by 60, which I understand, since we have:

FCFE = FCFF – Int(1 – Tax rate) + Net borrowing

However, according to the solution FCFF is not affected, i.e. the effect is 0. However, isn’t the formula for FCFF given by:

FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv

Shouldn’t FCFF increase by 60 in this case?

Thanks,

Tartaglia

#2

The “Int(1-tax)” part increases by $60. But the “NI” part decreases by $60. It is a wash.

FCFF is measuring how much is available to pay lenders and owners before either is paid… So you strip out any interest paid to lenders. Dividends don’t even get contemplated since they aren’t a component of NI. So essentially both dividends and Interest expense are excluded before seeing what is available.

#3

That makes perfect sense, thank you so much!!