I have come across this twice now in the ethics topic tests. They ask you to use FCFF or FCFE to evaluate the share price. They don’t explicitly say which formula to use, so I end up using the easiest one and get the answer wrong. Looking at the solution, they end up doing a longer way, even though all the data was there to use the simplest form of the formula.
This is pertaining to question 3 in Alahtab. They ask you to find FCFE, but they mention using the tax rate (which maybe should have alerted me). Using FCFE = NI + NCC + DEP - FCInv - WCInv + NB you get $1.03/sh but in the solution they first find FCFF using EBITDA and than convert FCFF to FCFE to get $0.92/sh.
Is there something that I am missing? They do suggest using the tax rate in the question, so is that a hint to use FCFF first?
Although there are 4 or 5 formulas for FCFF/FCFE, all formulas give the same results because they are all equivalent. So, you had wrong answers maybe because you just made wrong calculation.
I don’t think we should subtract interest x (1-t) when we start from net income. It is already deducted when calculating NI.
The problem of OP in my opinion. You MUST start with a number above tax (EBIT or EBITDA) because the question asks you to use the tax rate suggested by Whomever (I forgot the name) which is a different tax rate than it is used in the income statement shown.
Start calculating with EBITDA and you will have it OK.
EBITDA x (1-T) + Dep x T - Interest x (1-T) - WCInv - FCInv + Net Borrowing.
But don’t forget to use the correct tax rate which is given a few paragraphs below.
This is actually a fantastic question and I struggled with this for about 30 minutes before coming up with the answer. Hopefully this explanation makes sense if you haven’t yet figured it out.
Jatin (the senior equity analyst) suggests to Alahtab (you) that a tax rate of 35% is appropriate. When the income statement was originally published, it had a 32% tax rate. You know this because Income Taxes divided by Income Before Taxes (56.5 / 176.5) equals roughly 32%.
Because a different tax rate is being suggested, an adjustment needs to be made to the original amounts of Income Tax and hence Net Income. Income Tax (at 35%) then becomes 61.78 (as 176.5 * 0.35 = 61.78) and Net income becomes 114.73.
At this point, you can now use the normal FCFF formula (NI + NCC + Int(1 - Tax %) - FC Inv - WC Inv. From there, use the standard FCFE formula and you get the correct answer.
In this instance, EBITDA as a starting point is applicable because of the adjustment in taxes. If you simply start from Net Income, you’re essentially using figures that were derived from two separate tax rates.