It might seem trivial to you, but when calculating FCFF starting from NI, why do we add back interest * ( 1- tax rate), but add back depreciation in full, rather than depreciation * (1 - tax rate)? Thank you!
We add back interest net of taxes because that’s a use of FCFF.
We add back depreciation because it’s a noncash expense.
Different approaches because there are different reasons for the addition, and the nature of the expenses are different.
Thank you very much!
You’re quite welcome.
Magician, can you explain a little bit more what does “use of FCFF” mean?
You need to add back depreciation instead of depreciation*(1-tax) so as to take into account the tax benefit due to depreciation whi is depreciation*taxes in case you add back depreciation*(1-tax) then you are not taking into account the tax savings as a result of depreciation.
why don’t you add back depreciation(1_+_tax)?
Because if you do that then you do not consider the tax benefit due to depreciation (depreciation*tax).
Assuming that you have a job, you get cash flow net of taxes, and you decide what to do with it: you can pay your mortgage, buy groceries, bribe government officials, buy a Maserati, whatever. Or not. Those are all uses of your free cash flow.
A company has free cash flow: the cash it gets from operations, net of taxes, less what it has to spend to keep the company going at its current size (FCInv). The company can decide what to do with that cash: it can pay off debt, pay dividends, pay interest on existing debt, purchase a new patent, whatever. Or not. Those are all uses of the company’s free cash flow (to the firm).
Company A:
- Revenue = $1,000 (all cash)
- COGS = $600 (all cash)
- SG&A = $200 (all cash)
- Depreciation = $50
- Interest = $20 (all cash)
- Taxes are 20% (all cash)
- FCInv = $50 (all cash)
- WCInv = $10 (all cash)
What’s Company A’s FCFF?
Company B:
- Revenue = $1,000 (all cash)
- COGS = $600 (all cash)
- SG&A = $200 (all cash)
- Depreciation = $50
- No interest
- Taxes are 20% (all cash)
- FCInv = $50 (all cash)
- WCInv = $10 (all cash)
What’s Company B’s FCFF?
(Hint: it’s the same as Company A’s. Why?)
Company C:
- Revenue = $1,000 (all cash)
- COGS = $600 (all cash)
- SG&A = $200 (all cash)
- No depreciation
- No interest
- Taxes are 20% (all cash)
- FCInv = $50 (all cash)
- WCInv = $10 (all cash)
What’s Company C’s FCFF?
(Hint: it’s higher _ lower _ than Company A’s and Company B’s. Why?)
Thank you so much for your explanation!! Hope you had a great Easter weekend!
Company C should have a lower FCFF.
Good catch; my mistake.
I’ve gone back and fixed it.