Why do we generally take EBIT*(1-t) and not NI+Int.Exp in FCFF calculation?
Hello everybody! I have a small question on FCFF calculation.
Generally, we start from multiplying EBIT, let it be $100, by marginal tax rate (let's assume it 40%). As a result we get $60 which is attributable to shareholders and holders of debt. It is from these $60 that we later deduct change in working capital and CAPEX.
On the other hand, we can deduct interest expenses (let's take $20) from EBIT to come up with $80 of EBT. Then, we apply our tax rate (40% rate, hence $32 in tax expense) and get $48 of net income. If we sum up our net income and interest expense, we'll get $68 cashflow to shareholders and holders of debt, a sum which is higher by $8 than that derived in our first calculation. That is fair since we added an assumption about interest expense ($20)
My question is following. The two approaches give different answers. We stick to the first approach simply because it is faster? Or maybe there is some other issue I am not familiar with?
Thanks a lot in advance.
If you are computing the EV then you should not be accounting for the existing capital structure of the company. As well, the tax shield is included in the WACC and would thus be double counted.
hopefully this is helpful...
In scenario 1, only after you settle your Working Capital and Fixed Capital (CapEx) investments do you have FCFF,
I think the $8 difference in $60 and $68 is resulting from you not taxing $20 of Earnings in scenarios 2, that you plan to pay in Interest. $20*40%= $8.
It depends on what you are calculating - if you need FCFF (where you will discount cash flows to both equity- and bond-holders), you don't need the actual interest expense number as tax shield from debt is accounted for in WACC. However, if you are calculating FCFE, you need to adjust for the actual cash tax expense, so you would use the second approach.
Thanks for your answers. The difference is surely due to not taxing $20 of interest. If we simplify, EBIT(1-t)=EBIT - EBTtax_rate - Int.Exp.tax_rate I don't get why we deduct the last thing, Int.Exp.tax_rate. It seems that we have already eliminated all taxes from EBIT by deducting EBTtax_rate. Why are we deducting more taxes? This means double counting taxes, doesn't it? It seems that EBIT less EBTtax_rate gives a more accurate figure for FCFF as we are not overstating our tax expense. After that we will deduct changes in work. cap. and capex to discount the result by WACC with after-cost of debt. There is absolutely no taxes in numerator (FCFF) and in denominator (WACC with after-cost of debt), and the result is hence consistent.
I am basically trying to find out where is a flaw in my reasoning, if any.
It seems I got it; we're deducting Int.Exp.*tax_rate because the discount rate is also calculated on the after-tax basis.
Thanks.
If you add back Interest Exp at (1-tax rate) you are essentially going to get the same calculation as EBIT *(1-tax rate). Your problem is you're adding back the interest expense without accounting for the tax shield it provides.
Btw, your EBT and your IE depends on you B/S structure. Therefore, if you are doing a valuation from an Asset Side perspective, you can't simply do NI + IE since your current IE depends on a capital structure that you don't want to take into account.
This is why you do not take into account anything which goes below ebit when you do you FCFF. If you start from something which is below your EBIT, you are affecting your results by something which depends on you current capital structure, give the fact that any number you have as EBT and IP depends on you B/S assumptions.
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