Interest Tax Shield Revenue to Levered Free Cash Flow
I searched online for the formula but either they all start from net income or EBITDA or multiple sources give differing answers. I just thought starting from EBIT or Revenue differs because of the treatment of interest.
LFCF = (Revenue - COGS - Operating Expenses (inc. D&A) - Interest) * (1 - tax) + D&A +- change in working capital - capex - debt repayments
Can someone confirm for me if this is correct? I'm mostly confused about the subtracting interest part. Since multiplying (1-tax) to the entire first bracket takes into account the tax shield from interest (first bracket is taxable income, with interest already deducted), you don't have to subtract interest*(1-tax), just interest, is that correct? If you do [Revenue - COGS - Operating Expenses (inc. D&A) - Interest*(1-tax)]*(1-tax) instead, you would be double-tax-shielding interest, which makes no sense, is what I thought.
Any help would be appreciated.
LFCF is a measure of how much cash is available for the firm to return to its stockholders. Therefore, always start with Net Income as we have to include the impact of interest expense since it's a cash outflow to satisfy obligations belonging to debt investors in the firm. As for your question regarding taxes, I believe it's important to distinguish between LFCF and UFCF "tax" removal. When we calculate UFCF, we calculate NOPAT [ EBIT *(1-tax rate)]. However, it is essential to realize that the taxes paid when we calculate UFCF are purely imaginative as this is not actually the amount of taxes we pay out to the government. Instead, we make the implicit assumption that if the company has no debt (i.e. no interest tax shield), how much in taxes would the firm have paid out?
Conversely, when calculating the LFCF we care about how much cash is left for all equity holders. As a result, we can't use some imaginary tax amount but the actual taxes paid which will be reduced by the interest tax shield. Therefore, the formula " [Revenue - COGS - Operating Expenses (inc. D&A) - Interest(1-tax)]*(1-tax)" is wrong as you correctly identified that you would be double taxing your interest. All you need to do is solve for net income and make the necessary adjustment you highlighted to get to LFCF
Great, thanks for the help!
You're subtracting the pre-tax cost of interest and then multiplying EBT by (1-t) to get to net income. The first bracket term is just getting you to net income. It's all going to be from net income since you need to take out the cash flows to debt holders (interest expense) and just focus on the cashflows to equity holders when you look at levered free cash flow. So the formula you have listed there is correct, I think you're confusing yourself here. There is a valuation method called the APV method (alternate present value) where you value the debt tax shield separately and discount the unlevered free cash flows at the unlevered cost of capital then add the two values together. What you're referring to is something different.
I'm actually a bit confused by your question since I don't see interest double counted in the formula you posted. Can you clarify please? Remember you would be subtracting pre-tax cost of interest as you would in an income statement. Let me know.
Yup, I wanted to check whether the formula I listed was correct. I meant interest is double counted in the second formula I posted (not the first), which was supposed to be a deliberately incorrect example. Second formula in case you missed it: "If you do [Revenue - COGS - Operating Expenses (inc. D&A) - Interest(1-tax)]*(1-tax) instead, you would be double-tax-shielding interest, which makes no sense, is what I thought." Notice how in this one I included another "*(1-tax)" on interest as well as on EBT.
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