Free Cash Flow to the Firm Computation

CFA Level II Equities
#1

Schweser : “The formal definition of FCFF is the cash available to all of the firm’s investors, including stockholders and bondholders, after the firm buys and sells products, provides services, pays its cash operating expenses, and makes short- and long term investments.”

To better understand this, I created a scenario, but I have stumbled upon a problem. For the following Illustration, let’s assume that there are no Working Capital Investments (Hence, all revenues and costs are cash based), no Fixed Capital Investments, and no Non Cash Charges. Company A has revenues during the year of $120, it incurs costs of $20, must make an interest payment of $10, and has a tax rate of 10%.

Cash Flow to the Firm (Logical derivation)

+120 (Revenues)

-20 (Costs)

-9 (Tax at 10% on EBT of 90)

120 - 20 - 9 =91. (After I have generated revenues, paid off my costs, and paid of my taxes, I will be left with 91 DOLLARS IN HAND, which will be available for making my $10 Interest Payment, and for the equity holders). The problem arises when I create an income statement and then try to apply the FCFF formula :

INCOME STATEMENT

Rev. = 120

Costs = 20

EBIT = 100

INT. = 10

EBT = 90

Tax @ 10% = 9

NI = 81

FCFF (Formulaic Derivation) :

NI + INT (1-Tax) = 81 + 10 (0.9) = 81 + 9 = 90

In my logical derivation, based on the definition of FCFF, I have $91 worth of actual, hard cash left on me after all costs and taxes.

However, the formula says it’s $90.

I’ve been thinking about this a lot, and it’s messing me up. Could any explain the $1 difference in a way that makes it intuitive and clear to understand why FCFF should be $90 and not the logical $91.

#2

It’s because of the tax deduction on the interest. In your logical derivation you are excluding the $1 dollar in savings, whereas the actual formula accounts for it [INT (1-tax)]. Add back the $1 to your logical derivation: $10 (interest) * 0.10 ( tax rate) = $1

#3

Sorry, I mean subtract the $1, not add it back.

#4

This is how I’m looking at it - If you account for your tax savings, you should be INCREASING the cash flow by a buck, not subtracting it out. Hence, the $91 accounts for it, whereas the formula appears to be excluding it

#5

Just re-do the calc without interest and you will come to the right answer. You don’t have $91 as without paying interest you pay more tax by $1 as interest is deducted pre tax.

When using the calc from NI you add back int (1-tax) because NI has already benefited by the tax shield of 10% (i.e. $10 x 10%).

If you add back 10 then you are adding back the interest charge but not taking in consideration the reduced tax bill due to the interest.

You need to think FCFF is cash available to make payments, you are removing the impact of current interest payments. So cant benefit from the tax shield etc.

#6

Okay, I can go with that. Thanks