Hey fellow monkeys,
I have started to learn a little about modeling, and I have a few questions.
I read this: EBIT(1 - tax rate) = Net Income + Interest(1 - tax rate).
My question is about the "Interest*(1 - tax rate)" part. Why is the interest expense multiplied by (1 - tax rate)? Isn't it tax deductible?
Thank you
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Correct. However the reason they take the tax shield portion"(1-t)" is so to avoid the company receiving that benefit twice in a valuation. Take a look at the WACC equation --- where it also reduces the cost of debt by "(1-t)".
Fundamental Error is correct. You can prove this to yourself pretty easily if you write it all out in excel. For example, let's say EBIT is 100 and tax is 35% and Interest is 10. EBIT * (1-.35) = 65. In the other case, EBIT - Interest = 90, 90 (1-.35) = 58.5 = NI. NI + Interest *(1-.35) = 58.5 + 10(1-.35) = 65. 65=65.
I realize this thread is old, but this is a good question. In other words why do we apply a tax rate to EBIT and not EBT?
Remember that the purpose of calculating FCFF streams is to arrive at a present value of TEV for the entire firm, not just its equity. We use operating income (EBIT) not pretax profit (EBT) because operating income is a measurement of strictly the profits of the business itself, while pretax profit takes into account financing choices (more debt = more interest expense = lower EBT.) Consider two companies A and B that are identical businesses each generating 100 in operating income, but suppose A is financed 100% by equity and B is financed 80/20 and has, say, 10 in interest expense. Now if we were to set
FCFF = EBT * (1-t) + interest expense + .....
then that is giving an unfair advantage to company B, as its FCFF would appear artificially higher even though it is is the exact same business as company A and generates the same amount of cash flows distributable to equity and debt holders as well as the government. Therefore, we apply the tax rate to EBIT directly and ignore the tax-deductibility of interest expense for the purposes of calculating FCF to the entire firm.
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