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?

Comments (8)

Sep 18, 2018

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.

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  • VP in IB-M&A
Aug 30, 2019

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.

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Sep 18, 2018

Unlevered means no debt. No debt means no interest. No interest means no interest tax shield.

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Aug 30, 2019

About as good as an explanation will get...

  • Analyst 2 in IB - Ind
Aug 29, 2019

If unlevered FCF assumes no tax shield from tax, why does the corresponding WACC assumes leverage and tax shield (1-T) from debt?

Aug 29, 2019

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.

Aug 29, 2019

easy answer. unlevered FCF is the total value of the firms to both equity and debt holderss,and wacc is the expected return assuming a certian capital structure (so again something common both equity and debt holders as it takes into account their proportion)....hence the the orange-to-orange approach and by extention of which division of the former by latter makes sense...

Aug 29, 2019
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