Why don't we consider the interest tax shield when calculating unlevered free cash flow?
I've been confused for a while but basically I'm not understanding why we use EBIT(1-T) which derives to Net Income + Interest (1-T) instead of just Net Income + Interest. Why are we removing the effects of the interest tax shield?
Unlevered FCF = cash the business has before paying its financial obligations. Accordingly, EBIT(1-T), also known as Net Operating Profit after Tax (NOPAT), is a measure of profit that excludes the costs and tax benefits of debt financing. For avoidance of doubt: EBIT(1-T) = earnings before interest and taxes (EBIT) adjusted for the impact of taxes = NOPAT.
Answers below are all incomplete
Tax shield is included in WACC calculation by effectively reducing CoD. This way we can model a stable gearing going forward which would be pretty hard if you were to make a 3 statement model and had to guess how much debt you had to issue to achieve this.
Unlevered means no debt. No debt means no interest. No interest means no interest tax shield.
About as good as an explanation will get...
If unlevered FCF assumes no tax shield from tax, why does the corresponding WACC assumes leverage and tax shield (1-T) from debt?
Because we are not adding the tax benefit of debt to the cash flows (numerator), so we must do it through the discount rate (denominator) by taking the a/t cost of debt. It has to be one or the other, but not both as that will lead to double counting.
unlevered FCF is the amount of CF available to all investors, inc. both debt and equity. so you need to take into consideration the cost of both types of capital.
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