Why is interest expense ignored when computing FCF?
Can't understand the logic behind this one. Can anyone weigh in? ..........................................
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When doing an unlevered DCF, you're calculating FCFF (free cash flow to the firm), or just UFCF (unlevered). This is cash to the entire firm; cash to both equity and debt holders. Essentially, once you take get the NPV of all FCFF, you get the implied Enterprise value. Again, think about the equation of EV. Now if you were to include interest, you would be doing a levered DCF, calculating LFCF or FCFE (free cash flow to equity), because taking into account interest expense means that your earnings after tax was is interest-affected, so the remaining amount is available to equity holders. From my understanding, an unlevered DCF is used more often because it's easier to compare the models of two companies when ignoring capital structure.
Thanks this makes sense. So does that mean dividends aren't included in FCF also? (Since dividends are basically an "expense" for financing with equity).
Dividends aren't included in FCF calculation. Only place I've seen dividends are under the CF from Financing activities on the CF statement. Also, dividends are discretionary, not compulsory, The way you phrase it makes dividends sound like they are guaranteed or required.
It's to factor out capital structure.
It's because Investment bankers, unlike accountants are stupid and are clueless about where cash goes and comes from for a firm.
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