Finance costs vs Interest paid

CFA Level I
#1

Can anyone tell me the specific difference between the two, and should the ‘‘interest paid’’ figure simply be deducted from Cash flow from operations for calculating free cash flow ?

I often see, for example, a 200 million ‘‘Finance cost’’ deducted from the Income statement which is then added back to Cash Flow from Operations. So they cancel each other out, but then further down a 100 million deduction for ‘‘Interest Paid’’ under cash flow financing activities. So is ‘‘Interest paid’’ the only figure that should be deducted to calculate free cash flow with regards to simply investing ?

Thanks

#2

Rethink and rephrase your question. You’re all over the place :).

#3

There are a few ways you can do to calculate Free cash flow to firm:

if you are using from Net Income:

  1. you will need to add back all _ non cash charge s_ as well as interest paid (after tax)
  2. minus fixed & net working capital to derive Free cash flow to firm

if you are using from CFO (non cash & net working capital is taken care of)

  1. you will need to add back interest paid (after tax)
  2. minus fixed to derive Free cash flow to firm

Just be careful whether you are using US GAAP or IFRS

for GAAP (Interest paid is reflected under Cash Flow from operations)

for IFRS (it can be either in operations or financing)

  • If interest paid is under operations, add it back
  • If interest paid is under Finance, no need to add it back

Does this solves your question Gordgy?

#4

no name,

Thanks for the help.

I’m talking about UK stocks here so i guess its IFRS. So with UK companies it seems ‘‘Financing costs’’ are generally deducted in the Income statement and then added back on in CFO (like depreciation). Whilst the ‘‘Interest Paid’’ figure is either deducted under CFO or CF from Financing.

But from purely from an investing perspective what about when a company has so much debt that it will be paying off its interest for the next 5 to 10 years. Doesnt this interest cost then become part of everyday operations and so should be deducted to arrive at FCF ? Or with these high debt stocks should you simply compare any DCF to the Enterprise Value , rather than the market cap ?

And high debt, high interest paying companies/stocks should generally be valued using Free Cash Flow to Firm?

Thanks again.

#5

your welcome

I am struggling alittle to understand your question, but I will try

Interest cost (regardless high or low interest) must be added back to free cash flow

Definition of free cash flow =$ that is available to both stock & debt holders

In this case interest cost is an asset to debt holders , and therefore must be added back (if it wasn’t added to CFO)

Unless you are planning a takeover, in this case EV will be a better matrix because the the acquirer would ultimately keep the cash and assumes only the debt portion

On your last question, should they be value using free cash flow to firm: it really depends on what you want to value the company for. Keep in mind you could use free cash flow to equity as an equity holder

Hope this helps

#6

Thanks again,

I think the confusion is that with my question i had valuation models in mind rather than accounting practices. Valuation as an equity holder that is.

My bad.

I have basic questions like when valuing a stock/company as an equity holder do you always use the FCFE model rather than FCFF ?

Cheers

#7

Stop trying to integrate the information. On the test, Equity will be equity, and FRA will be FRA, and there will be no mixing the two together. (At least at Level 1)

You will get a very healthy dose of this at Level 2.

#8

Is FCFE a better model than FCFF when valuing company as a minority shareholder: Yes Do I always use FCFE model: No It depends on the characteristics of the company, what stage its in etc FCFE will be more appropriate if the company does not pays dividend, if it does, you might want to consider discounted dividend model Bear in mind in CFA curriculum, you will come across many different type of valuation model, and especially so when you move up next level Even after completing all 3 levels, you need to be aware too that there is not 1 template valuation model can be used for every companies If there is, then every single one of us will have the exact same price target as all others out there