Confusion on FCF - Adding back Int(1-t)
Hello,
I know this question has been asked many times, I've reviewed all answers, but my confusion has remained the same. I know FCF = Cash flow available to debt and equity holders.
I am genuinely confused on why I would add back interest expense. Moreover, I know the concept of tax shield, but I want to know how it is adapted in this context. I do however understand why we add back depreciaiton.
I usually try to solve these problems by applying generic examples, but I will apply one now and show you where i'm confused:
Assume: Interest = 800,000; Depreciation = 2,000; Tax Rate = 10% .......... This would mean we have a tax shield for interest of 80,000 and tax shield for depreciation of 200. Now FCF says I have to add back Int(1-t); so I am adding back 720,000 worth of Interest.
1) Why did I add back 720,000 and not 800,000? It is as if the tax shield hurts a debt holder as the company's value becomes less after we include the tax shield
2) How can we account for interest expense if we are adding back change in NWC whereby the change in interest payable is already accounted for WACC we use to discount? Do we still do Wd(Cost of debt)(1-t) or do we only use Wd(Cost of debt) portion?
4) Why dont we account for the tax shield that depreciation creates?
Thank you, I am genuinely and utterly confused ...
> 1) Why did I add back 720,000 and not 800,000? It is as if the tax shield hurts a debt holder as the company's value becomes less after we include the tax shield
Assuming you're starting with net income and working backwards, the simple answer is that net income has already factored in the tax shield from interest. The company's value doesn't become less, it becomes what it's supposed to be since because 800K of interest was paid out to debt holders, the company pays 80K less of tax. That's why when you add interest back, it has to be the after-tax interest.
Mathematically:
EBIT * (1 - T) - Interest * (1 - T)
= (EBIT - Interest) * (1 - T)
= EBT * (1 - T)
= Net income
Therefore, net income + interest * (1 - T) = EBIT * (1 - T)
> 2) How can we account for interest expense if we are adding back change in NWC whereby the change in interest payable is already accounted for 3) If we do add back Interest(1-t), what happens to the WACC we use to discount? Do we still do Wd(Cost of debt)(1-t) or do we only use Wd(Cost of debt) portion?
Simple. Since you have factored in the after tax cost of debt (i.e. interest * (1 - T)), you should use the after tax cost of debt in WACC.
> 4) Why dont we account for the tax shield that depreciation creates?
Mathematically it makes sense to do so, but remember that FCFF is a measure of cash. Depreciation itself is a non-cash expense which results in a cash tax shield, therefore you should back out the entirety of depreciation and not just the after-tax depreciation, since the tax amount was real cash that left the company as taxes.
Thank you so much! Your input was of massive help!
May I just comment on two things you mentioned?
Not too sure what you mean. NWC is computed from balance sheet items, mainly current items like receivables, inventory and payables. Interest expense is a non-operating item and should not be related to working capital.
**So what you're saying is that when I am calculating FCFF and adding the change in Net-working capital, I should not embed the Interest Payable portion on the balance sheet? Because what if it appears during my projections, are we projecting that we aren't paying it off (i.e: the interest payable portion on the balance sheet increases and never decreases)? **
Mathematically it makes sense to do so, but remember that FCFF is a measure of cash. Depreciation itself is a non-cash expense which results in a cash tax shield, therefore you should back out the entirety of depreciation and not just the after-tax depreciation, since the tax amount was real cash that left the company as taxes.
When you say back out the entirety of depreciation, you mean add the whole amount back correct? Alright, so how does the model embed the tax shield that depreciation created. Sorry I know you have answered this already, but I am just trying to dig into your answer further so I can understand it using simpler language as my english is not great. Is the tax portion also embedded since we started with net income?
> So what you're saying is that when I am calculating FCFF and adding the change in Net-working capital, I should not embed the Interest Payable portion on the balance sheet? Because what if it appears during my projections, are we projecting that we aren't paying it off (i.e: the interest payable portion on the balance sheet increases and never decreases)?
Ah okay, I get what you mean now. Interest expense and interest payable are very different! Yes, interest payable is a current liability and is typically included in working capital calculations. Caveat here is that some transactions do not include it as it is a financial item and not an operating item.
> When you say back out the entirety of depreciation, you mean add the whole amount back correct? Alright, so how does the model embed the tax shield that depreciation created. Sorry I know you have answered this already, but I am just trying to dig into your answer further so I can understand it using simpler language as my english is not great. Is the tax portion also embedded since we started with net income?
Yes I meant add the whole amount back. Basically, what I mean is that because depreciation (non-cash item) results in a tax shield (cash item), we have to treat it differently from say, a cash item like interest expense. Since FCFF is a cash flow, we have to remove the effect of a non-cash item like Depreciation. However since the tax shield provided by depreciation is actual cash saved by the firm, it has to be considered. Therefore, we add back the whole depreciation amount and not just the after-tax portion.
Hope this is clearer!
Thank you so much I am very grateful for your replies.
One last question since you mentioned it: Interest Expense and Interest Payable are very different in what sense? Isnt the Interest Expense created when the Interest Payable amount on the Balance Sheet Increases?
Note: I really want to thank you, you are helping me greatly!
Don't worry about it mate. All good.
Interest expense is a P&L account, while interest payable is a balance sheet account (more specifically, a current liability). Interest expense is what you incur on the debt you take on, and can be as simple as multiplying the debt principal by the interest rate. Interest payable is an account that measures how much interest expense has been incurred AND not paid off as of the date of the balance sheet.
Simply put, you can think of interest payable as this:
Interest payable as of this period = interest payable as of last period + interest expense incurred during this period - interest paid during this period
Thank you endlessly sir! Bookmarked and saved and printed this thread to carry on with me for good (:
So when we are accounting for FCFF and Interest Expense, we embed it by starting from Net Income (whereby we already deducted Interest Expense), but to reimburse the FCFF with the actual cash spent on Interest and not only expensed, we look at the change the Interest Payable from period to period to see how much of the interest portion was expensed and how much was paid in cash!
People always get this wrong but unlevered FCF does not take into account the interest tax shield, that is clear from the definition starting with EBIT*(1-t). The reason is that you discount it with WACC which used after-tax cost of debt which accounts for the interest tax shield - hence we’re not double-counting it.
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