FCFF from CFAI text first, increase, interest, several

pacmandefense

Was looking at the end of topic questions for Free Cash Flow and the first Q asks for the effect on FCFF and FCFE for an increase of 100 on several NI and BS items. Assume 40% tax.
for an increase in interest expense of 100 it says it has NO effect on FCFF and -60 for FCFE which is clear.
shouldnt interest expense increase FCFF????

Spongebob

I don’t have the books in front of me and I’m not familiar with the question, but it sounds that they are asking you to determine the effect and not calculate starting with net income.
If that’s the case – you’re not starting with NI where Interest Expense is already subtracted – then you want to ignore Interest Expense for FCFF (pre-levered – so int doesn’t affect the FCFF).
Think about it…if you are starting with a clean slate, would you add interest expense to determine FCFF. No. You only add it back to net income to determine FCFF, because int expense is taken out of NI from the start and FCFF is pre-levered (before interest).
Please correct me if I’m wrong.

farrukhsadiq

I will take a stab at it..
I would venture to guess that since FCFF = NI + NCC + Int(1-t) - FCinv - WCinv that 2 things happen when you increase interest.
1) Int(1-t) increases by 60.
2) NI decreases by 60.
This offset would cause no change in FCFF.
For FCFE, you want to back out the interest cost, because this is truly not free cash flow available to an equity holder. (Interest cost is free cash flow available to the debt holder however, because they are the ones receiving the interest)

Iginla2011

yup makes a whole lot of sense thanks.