Free Cash Flow Question
Dumb question, especially as a second year analyst but this popped up in my head and my friends can't help me. so we know ULFCF is EBIT(1-t) + D&A - change NWC - capex
Why do we take EBIT (1-t) instead of EBT (1-t) + interest + D&A - change NWC - capex
If interest is "tax deductible" then wouldn't taking taxes on the money BEFORE taking out interest not account for the tax deductibility?
Think of this from D&A's perspective, we say D&A is tax deductible right? so that's why we separate it and take off D&A before adding it back, that way we aren't taxed on the D&A so why isn't interest the same thing?
Because as I understand it ULFCF is the cash flow available to all investors (debt and equity). If you subtract out interest, you are essentially going to LFCF and looking at cash flow only available to equity holders. Also, D&A is a non cash expense. Whereas interest expense is a cash expense for the most part, unless it's PIK debt. So it makes sense to add D&A back but not really for interest expense.
I get your point that you're trying to add the tax shield that interest provides. However, the simplest way to think about it is for unlevered free cash flow is that you are trying to stay above the interest expense line on the income statement to analyze cash flows available to debt and equity investors. To add the tax shield effects from interest expense, you would be going below EBIT. It's not analogous to add tax shields of debt without subtracting the cash flows paid to debt holders. Hope this makes sense
thanks, great write up
This makes sense; however, wouldn’t you still be overstating your income tax expense thus understating FCF to debt and equity holders? Maybe there’s just no better way to do it without going below the interest line.
You would be overstating income tax expense, and that's true if we look at it in a vacuum. I think I would focus mostly on the last sentence in my response. It does not make sense to account for the tax shields that interest expense provides without subtracting the cash flow paid to debt holders. You only get tax deductibility of interest indirectly by paying (or incurring the expense) the interest. So as I see it, you pay (or incur) the interest first, and then that payment is reflected on the income statement and deductible for tax purposes.
For an apples to apples comparison, it does not really make sense to add the cash flow of the interest tax shield without subtracting the primary creation of that cash flow (interest expense). Sort of like a cart before the horse scenario. And since we are looking at ULFCF, we would not want to subtract interest expense because then the cash flow left would only be available to equity holders. Let me know if that clarifies things
Because interest is capital structure dependent. D&A is capital structure agnostic.
ULFCF is capital structure agnostic.
Apples to apples.
I’ve seen UFCF used two ways, firstly for valuation purposes where you’re doing an unlevered DCF or where you’re looking at EV as a multiple of UFCF. In that case it makes sense to ignore interest payments especially in the multiple scenario as you want to compare apples to apples and look at capital-structure-agnostic cash-generation potential of each business.
The second way I have seen UFCF used is in a model where you have the line item at the top of the debt schedule. Maybe it’s sloppy nomenclature on my part but there I would subtract the actual taxes paid instead of the EBIT*(1-t) as you want to know the actual cash available for debt servicing (normally for convenant related reasons, or maybe you are modelling a PIK-toggle instrument).
First approach is probably more “theoretically” correct but second way is the only way that makes sense to me in a model.
Because you’re doing an unlevered free cash flow valuation, not a levered one.
When you buy a company you use EV so you are getting it debt free. If you include interest you’re distorting valuation and assuming you’re stuck with the existing cap structure.
Earnings before taxes * (1-Tc) + Interest simply recognizes the tax shield from interest. We don't want to recognize the interest tax shield in the ULFCF, that's why we calculate after-tax cost of debt in the WACC. Unlevered free cash flows are what the cash flows would be if firm were unlevered, in which case interest expense would be zero, and there also wouldn't be a tax shield from interest. Interest tax shield in WACC. Depreciation tax shield in ULFCF.
Actually thats what I dont get here. As we use a cash flow which is unlevered, why do we consider tax shield in our WACC? Anyone on this?
Got asked this in an HL interview today - according to the Director who asked the question, EBIT*(1-t) overstates tax expenses, while given the fact that we are discounting unlevered CF, Cost of Debt * (1-t) understates the interest paid, eventually these two balance out.
According to him this has been covered in academia. I am currently searching for articles on this, as I didn't find his explanation sufficient (he didn't do the math).
It's not appropriate to make the comparison to D&A. It conflates two completely different things which is what is leading to the confusion.
For unlevered FCF, you can start below the line at net income as you sugggested. However, if you start at net income, you will need to reverse the flow-through of interest expense because unlevered FCF assumes the company has no debt. To do this, you would add back the after-tax interest expense (not the full interest expense as you laid out) so as not to double count the tax shield from interest expense.
In the case of D&A, the company is still incurring the D&A expense. However, the reason we add back D&A is because it is a non-cash expense. And we add back the entire amount of D&A (not just the after-tax portion) because of the tax shield that is created from incurring the D&A expense.
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