Unlevered Free Cash - Conflicting Definitions From Interviewers
Start with EBIT. How do we calculate cash tax?
1. EBIT*(1-tax rate)
or
2. (EBIT-interest)*(1-tax rate)
then we add back the interest in a DCF since we want unlevered free cash
In doing a DCF, the interviewer told me that we use #1 since the debt portion of WACC is shielded by the tax rate. If we use the interest as a tax shield at the EBIT level, we'd be shielding it twice. Really doesn't make any sense to me.
In another interview, I was doing an LBO for the guy. In calculating cash flow available for debt service/levered free cash, we use #2 and don't add back the interest afterwards.
How do we calculate cash tax? from EBIT or EBIT-interest.
EBIT already has interest backed out of it, #2 would simply subtract it again which doesn't make sense.
i mean, taking interest out to get to taxable income, calculate cash taxes, subtract cash taxes and add back the interest you took out at the beginning.
ebit - interest expense * 1-tax rate is just net income. understand? then add back non-cash expenses, subtract change in working capital, capex, etc and you have levered fcf / cash avail for debt retirement for LBO. for a DCF, yes wacc accts for tax shield so you don't subtract interest.
Thanks for the explanation.
I was always under the impression that the only difference between levered and unlevered cash flows is the interest expense+required amortization. So the difference in calculating tax (higher tax for unlevered free cash) is another difference. correct?
If you added back interest expense after taking out taxes, you'd be realizing an interest tax shield, which of course is dependent on your capital structure.
which would mean that it'd levered, not unlevered. So the reason for calculating tax using #1 is to not recognize the tax shield (hence unlevered). think i'm starting to get it.
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