Hi Guys,
Had a question about free cash flow. Why dont we add back depreciation after tax since it is tax deductible? I mean we add back interest expense to CFO after tax as well. Just a little confused. Appreciate any answers.
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I have seen a couple ways to compute FCF: 1) EBITDA - Changes in working cap -capex 2) CFFO - capex - + interest (1-T) 3) NI + interest(1-T) + noncash income-capex-changes in working cap
The only method where you would be adding back depreciation and amortization (method 1) you are considering interest pretax also (EBIT is before taxes) so from an apples to apples comparison you would also be adding D&A back without tax effecting. When looking at example 3, net income is aftertax so it makes sense to add back the aftertax interest expense
With respect to method 2 CFFO already encapsulates D&A. By adding back tax effected interest (thus getting to the actual interest paid) you are adjusting CFFO for financing cashflows (so essentially valuing cash flows on a financing agnostic basis - if you are doing a DCF your capitalization comes into play when you compute the WACC) and then adjusting for investing cashflows by subtracting out capex.
This is long winded but i think the essential difference between interest and d&a is that d&a is noncash - so its an accounting mechanism but no cash will ever actually change hands. interest expense will ultimately be paid and you need to also look at the taxes you aren't paying...
Someone else correct me if this is off base / if you have better intel.
I'm a little confused about method 1. Isn't it usually EBIT(1-tax)+ D&A - change in NWC -capex? That is after tax. This is why I'm confused because you add back depreciation and amortization in full amount as opposed to after tax.
Cash flow from operations includes the net tax the business has paid i.e. it has already accounted for the tax shield provided by depreciation. Depreciation is a non-cash expense, but adding it back doesn't change the fact that your cash tax liability was already reduced by that depreciation.
Now, I am assuming you are solving for unlevered free cash flow, which looks at what cash the business hypothetically generates assuming it had no debt. In that case, when you add back the interest you need to account for the tax shield because without the interest you would have a higher cash tax liability.
Hope that helps.
Thanks for the answer. I understand there's a tax shield for interest, but why not for depreciation/amortization? Depreciation also reduces your taxable income.
Exactly. So like interest, depreciation is tax deductible, and it directly impacts cash flow. But if you were to add depreciation back net of tax, that would nullify the positive cash effect depreciation's tax shield has on CFO. Whereas the reason you add back interest is not because it's a non-cash item (it is), but because you want to see what is the effect if interest did not exist in the first place. Does that make sense?
Oh so by not adding it back after tax you are actually accounting for the tax shield? Do you mind explaining that rational a bit?
Nevermind I just did the math and it makes sense. Thanks so much!
I kind of have a follow up question. Why dont we ever do the same for depreciation(pretend that it doesnt exist)?
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