FCFF Question

CFA Level I Equities
#1

Hi all!

During my studying i always calculate FCFF just mechanically, but today i started to think, why do we have to add interest adjusted on tax, rather than just interest.

As far as i know, we do not pay tax on interest, but we pay tax on principal(for example: amortized bank loan, TLA), i’m i wrong?

My question: In the table below, why do i have to add int*(1-t), in my case - $18 instead of $30(interest). I can’t understand: we adding back $18, but we still have to pay $30! i’m tolking about interest, not principal.

FCFF - it is cash available for the all(debtholders, stockholders), before we were been able to pay $30 interest, but after adding back interest*(1-tax) we can pay only $18 = 30*(1-40%).

I’m so confused((.

Please hepl me, Thanks in advance!

Here, I’ve made the table: tax - 40% By the way, I would apperiate if someome tell me how to create Table :slight_smile:

Revenue 400 - COGS 150 = Gross Profit 250 - OpEx 100 - SG&A 20 = EBITDA 130 - D&A 50 = EBIT 80 - Interest 30 = EBT 50 - Tax 20 = Net Income 30 + D&A 50 - CapEx 40 + Interest*(1-t) 18 - Increase in NWC 10 = FCFF 48

#2

You add int(1 – t) because that’s the cash flow for interest: you pay int and you save int × t on your taxes.

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#3

Why “add”? Net income was derived at by subtracting these cash flows. Interest has already been paid to the debtholders. So, “free” cash flow shouldn’t include interest. What am I missing? Kindlt simplify this for me S2000Magician. I have been headbanging on this for quite sometime and everytime I read it, I forget the reason.

#4

FCFF – Free Cash Flow to the Firm – is cash flow that is available to pay to all suppliers of capital: bondholders and stockholders. The cash (net of taxes) that is paid to the bondholders as coupon payments is part of that free cash flow; we know this because it’s cash flow that was not merely available to pay suppliers of debt, it was, in fact, used to pay suppliers of debt. It’s subtracted to get to net income – an amount after we used cash to pay the bondholders – so we add it back to tell us what was available (before we used it).

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#5

But we paid “interest” to the bond holders. Why “net of taxes” is included in the definition? Intuitively, it doesn’t make sense to me, because “interest” was available “initially” i.e. before we paid the interest.

Also, can you give an example of cash flow that is merely available to suppliers of capital, because I don’t understand “merely available”. The way I look at it is, nothing should be merely available then. Even if you draw out money from “Reserves and surplus” to pay out to the bondholders, it shouldn’t be considered “merely available”.

FCFF is free cash flow available in that financial year, right?

#6

And the government paid interest × t to us; the net cash (out)flow from paying the bondholders is interest × (1 – t). We subtracted that to get to net income, so we have to add it back to show that it was available.

If we sell a million widgets, generating $10 million in cash, we pay $2 million (net of taxes) to our bondholders, and $1 million to our stockholders, then we had $10 million available, $3 million used, leaving $7 million available (but unused). I was trying to distinguish between cash flow available to the firm and cash flow available to and used by the firm: the former is $10 million, the latter is $3 million, the difference is $7 million.

Yes.

#7

I am really sorry, because this is a very silly question to ask at this point in time, especially after studying the whole of it, but why did the government pay interest * t to us?

In our example on $10m revenue generated in cash, the intr paid out to bondholders is $2m. Let’s say the tax rate is 30%. So, why will the govt pay me $0.6m?

I know you are trying to say it as a way of looking at the problem, but I don’t understand exactly.

#8

Because the government loves us.

If we hadn’t paid the interest to the bondholders, we would have had to pay $3 million (= 30% × $10 million) in taxes. Because we paid the interest, we have to pay only $2.4 million (= 30% × ($10 million – $2 million)) in taxes. The difference is $0.6 million. You can think of it this way: we paid $3 million in taxes, then the government paid us $0.6 million, for a net of $2.4 million in taxes.

Either way you look at it, we have a cash (out)flow (for taxes) that is lower by $0.6 million because we paid interest to our bondholders. We paid them $2 million, and saved $0.6 million, so net, we’re out only $1.4 million (= (1 – 30%) $2 million); that’s our net cash (out)flow.

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#9

I have been roaming around in my dorm for the past one hour thinking about this. I still don’t understand :frowning:

Consider that I am a firm. I generate 10m in revenue this FY. Subtracting the COGS (which is based on the inventory valuation method I choose), I get my Gross Profit. Now, this Gross Profit is not all Cash, because some of the sales could have been credit sales.

Now, SGA Expenses are fixed expenses (loosely put; I mean if the workers are variable, payrolls would be proportionate) per year. This cannot be available to bondholders and stockholders. Doing the rest of the calculation, I arrive at Net Income. Now, I need to know what was the cash that was available to the bondholders and the stockholders of the company (FCFF). So, starting out with the net profits to the firm, I add back NCC (depr and amortization). Whatever I ve paid out to the govt isn’t available to the bondholders and stockholders. When I pay interest to bondholders, I pay less taxes to govt. So, while calculating back, I should adjust for appropriate tax rates and then calculate what is actually available to bondholders and equityholders. (Now, I started overthinking and got confused again. I have already paid out intr to debtholders, so that much amt of cash was made available to the by me. As a result, I pay less taxes to govt. FCFF is cash flow available to debtholders and stockholders. So, the interest paid is what we made available to them and it should be added back to the net profits after subtracting whatever taxes (less or more as a result of interest paid) we paid to the govt. (These taxes have already been subtracted to arrive at the net income, so they shouldn’t be subtracted again from net income)) We’ll also subtract any Capex and working capital incurred this year from Net Income+NCC. We are subtracting capex because Net Income, when arrived at, doesn’t cosider any capex and when we want to calculate the cash which is available to bondholders and stockholders, we need to subtract the change in capex y-o-y (year-on-year) from the profit generated from operations. Similar explanation goes for working capital.

#10

Any insight on this one?

#11

Just wanted to review this. Can anyone help me understand this?

#12

FCFF = Free cash flow to the firm, we both agree on this by now :slight_smile:

Therefore we need to determine how much cash is available before we pay both lenders and shareholders. You can therefore re-define FCFF as “cash flow generated by the firms assets, before any financing decision”

Of course, as you know a firms assets can be either financed by debt or equity. if financed by debt, we must pay interest. Further, interest generates a tax shield - if we pay interest, we get a tax shield of interest * t

Let’s say we start at free cash flow , which is operating cash flow - capital expenditures.

let’s also say that some of the assets were financed with debt, so there are some interest payments we must make. Of course, because we paid interest, we also generate the associated tax shield.

So, right now, we have:

FCF = OPCF - CAPEX

OPCF is NET of both the interest payments and the tax shield generated by the interest payments

What we want however is FCFF - the cash flow generated by the assets, regardless of the financing decision

Since we used debt to finance the assets, we need to adjust OPCF by the interest we paid in order to determine the asset free cash flow.

  1. The first step is to take OPCF and add back interest payments.

We now have OPCF + Interest payments - CAPEX; but this isn’t the full story because we also generated an interest tax shield, which was ONLY generated because we paid interest.

  1. What we need to do is adjust the above to: OPCF + Interest payments - Interest tax shield - Capex = FCFF

(if we didn’t pay interest, we would not have tax shield!!!, so if we add back interest, we must subtract the interest tax shield)

Further, Note that if we add back interest payments and subtract the interest tax shield this is equivalent to adding back post-tax interest payments

Example:

interest = 100

tax = 20%

add interest (100), subtract tax shield (20), or just add-back 80!

Cheers

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#13

@carthurj: Thanks a ton. You nailed it! I’ll summarize it below: FCFF means what the firm will generate because of its assets in a FY. We want to calc what the firm would have generated independent of how its assets have been financed. Generally, firms raise debt and with debt comes tax shields…You save “Tax shield” amount of money in your regular operations, which came in the first place because of interest payments, but we have to calculate how much is generated by the firm independent of whether that money (loosely put; to express in a layman’s language) was received via equity/ debt. So, that interest which we have already factored in while calculating our net income must go first. That said, tax shields will go away too, since, interest is now gone. So, we add back interest adjusted for tax shield to out net income. Now, since we are talking about “cash flow”, we needs to adjust net income too. We do that accordingly. In the FY, the firm must have invested in the form of capex also. We need to calc what is the “cash flow” to the firm. Hence, we must adjust our cash flow for this spending. Now, what we have is our FCFF!

Boo-yah!

On this note, could you let me know if my understanding about FCFE is correct?

FCFE is free cash flow to the firm’s equity holders…hence, cash flow that is available to the shareholders only. Now that we have mentioned “shareholders” explicitly, I believe we trying to calculate cash flow available to them after debt obligations have been met. So, if the firm raises x amount via debt financing in a FY and repays y amount to debt holders…then x-y is the net debt raised _ in that FY _. So, CFO adjusted for CAPEX and this in turn is adjusted for (x-y)

FCFE= CFO-capex+(x-y) One thing worth noting is that we need not adjust for interest shield here, because it is implicit in our calculation that interest has been paid and we want to calculate cash available to shareholders dependent on the conditiopn that there are debt holders too!

Brilliant! Can’t thank you enough @carthurj!

#14

Take a bow!

#15

you got it my friend! well done. you’re right, for FCFE, there is no need to, as we say “unlever” the cash flow by adding back interest and subtracting interest tax shields. We must simply add debt financing inflows (debt issuances) and subtract debt financing outflows (debt repayments).

Then discount the FCFE at the required return on equity and that is the value of the firms stock.

#16

Hi Carthurj, thanks for taking the time to explain this as I have the same question. Unfortunately, and with apologies in advance, I am still unclear. Depreciation also provides a tax shield since depreciation is also a tax-deductible expense (albeit a non-cash expense). Why do we just add back depreciation without multiplying it by (1-Tax Rate) when we multiply interest by (1-Tax Rate)?

#17

I think that S2000magician doesn’t understand much at all about financial statements or, especially, cash flow. Therefore, blackjack21, let me see if I can be helpful to you.

For starters, if someone holds a gun to my head and tells me that I can have only one of the three statements that describe a company’s financial activities–the balance sheet (BS), the income statement (IS), and the statement of cash flows (SOCF)–I’ll take the SOCF every time. But I’ll do that only if it’s presented on the ‘direct’ basis. Let me elaborate.

In the U.S., accounting standards–known as GAAP (Generally Accepted Accounting Principles)–are set by the Financial Accounting Standards Board (FASB). Regardless of whether the ‘direct basis’ or the ‘indirect basis’ of presenting the Statement of Cash Flows (SoCF) is used, SoCF has three sections:

  1. Cash Flows from Operating Activities;
  2. Cash Flows from Investing Activities; and
  3. Cash Flows from Financing Activities.

In addition, no matter which method of presentation is used, the section related to “Investing Activities” and “Financing Activities” are the same. The only difference–and it’s a significant one–is in how the section about “Operating Activities” is presented under the ‘Direct’ and ‘Indirect’ methods.

In the The Indirect method of presenting the SOCF, the Operating Activities section starts with Net Income. Because Net Income is on the ACCRUAL basis, but we’re concerned with CASH, adjustments are required. Those include the following:

  1. adding back Depreciation Expense (because it’s a non-cash expense);

  2. adding back the year-over-year (YOY) decrease, or subtracting the YOY increase, in Accounts Receivable;

  3. adding back the YOY decrease, or subtracting the YOY increase, in Inventory;

  4. adding back the YOY increase, or subtracting the YOY decrease, in Accounts Payable; and

  5. adding back the YOY increase, or subtracting the YOY decrease, in Accrued Expenses Payable.

In contrast, the format for the “Operating Activities” section of the SOCF on the direct basis in simple:

  1. Cash received from customers;

  2. Cash paid to suppliers;

  3. Cash paid to employees;

  4. Other operating expenses paid;

  5. Interest paid; and

  6. Income taxes paid.

For investors and other consumers of financial-statement information, I am of the firm opinion that the ‘Direct’ method has it all over the ‘Indirect’ method. Most accountants don’t like it, but the ‘Direct’ method is far more investor-friendly. And, since investors ultimately pay the accountants’ bills, I am of the firm opinion that the ‘Direct’ method is a much better way to present the Operating Activities section of the SoCF.

#18

I’m not sure how you reached that conclusion, but I assure you that it’s wrong.

#19

Given that blackjack21 posted this 7 years ago, he/she is unlikely to see your reply now.

#20

The key difference is that depreciation is an expense that we take irrespective of how the depreciable asset is financed, while interest is an expense that arises specifically because of how assets are financed. Because we get the (cash) tax saving on depreciation irrespective of how the asset is financed, that tax saving enures to the firm. That tax saving is included in net income, so we don’t have to make an adjustment for it when going from net income to FCFF.

The depreciation expense, however, is, as you pointed out, a non-cash expense, which was deducted to arrive at net income. Therefore, we have to add it back to get FCFF.