CFA CFA Level 2 Deferred Taxes in FCF

# Deferred Taxes in FCF

• Author
Posts
• vincentt
Participant
• CFA Level 3
146

Was going through M&A in the topic Corporate Finance, and here’s the formula to calculate the FCF.

NI
+ Net interest after tax
= Unlevered NI
+/- change in deferred taxes
= Net operating profit less adjusted taxes (NOPLAT)
+ NCC
+/- change in net WC
– CAPEX
= FCF

My question is to do with the change in deferred taxes, from what I understand you would have to add deferred tax liabilities and deduct deferred tax asset.
However, in schweser notes example (Book 2, p355), change in deferred taxes were given as \$17, \$19,….. for each year. Since it’s a positive figure, I would imagine that you would have to deduct it, but the book adds it back. Does anybody know why?

• 9

@vincentt: not at all, I find your thought process very clear and logical, and you do grasp things quickly and actually learn and not just purely memorising! It’s admirable ðŸ™‚

• vincentt
Participant
• CFA Level 3
6

@sophie Just hope that I’ll be like you in one of your blog post during the exam ðŸ˜›

• 6

@vincentt no I haven’t. I only did it for chapters I was having difficulty on. Right now I am doing some revision because I’ve managed to forget half the curriculum.

• 5

Got it. Thanks @vincentt and @diya!

• 5

@vincentt, I’m just using @diya’s example and assume that was the question in the book.

The question shows you the breakdown of DTA and DTL, and gives you the ‘net’ figure of \$19 and \$17. As you can see the DTA was stagnant but DTL increased. So if the expectation is that DTL increases and won’t reverse, you should add DTL back to NI.

It’s misleading to judge just by the net figure, as it could be due to increases in DTA (which if permanent, should be deducted from NI as you said) or decreases of DTL (or both).

• vincentt
Participant
• CFA Level 3
5

thanks @sophie, maybe i should post a screen shot of the page.

The DT is increasing, wouldn’t that be a sign of DTA?
I’m just not sure, if we should go into the detail of each NCC items like the one in equity chapter as this is corporate finance (and maybe should only be just + NCC regardless)?

• 5

@vincentt, no not at all. I just read through and realised I didn’t make much sense, no worries!

I think I found the source of confusion. The deferred taxes here is an expense item in income statement (in addition to current year tax expense), not a balance sheet item (not stated an asset or liability). It’s in P&L due to the matching principle, allocated during the period to cover tax liabilities that have not been paid. It’s a non cash charge (expense).

• vincentt
Participant
• CFA Level 3
5

thanks @sophie I think that make sense, as DTA/DTL should be in the balance sheet, but if they did not mention that it’s not reversible in the foreseeable future should I assume that it would be just pure NCC and add both (DTA/DTL) back to NI or ?

• 5

Oh I’m not discouraged @diya. i’m just hoping to scrape through – I know I’m not devoting as much time as I know I should…

• Zee Tan
Keymaster
• CFA Charterholder
5

sometimes I know the formula but get confused if the question isn’t straight and they throw a curve ball…

That’s to be expected at this stage – it straightens out after a few rounds of practice!

• 4

Ok, they have already nicely calculated the change in deferred taxes for you, so as you said, it’s a positive number, you apply the formula of adding (since it’s positive) changes in DT for 2007.

No need to delve in depth about DTA and DTL specifically in this case

• 4

@vincentt I’m confident you will kickass ðŸ™‚ – without the Hillary’s funny face though.

Just keep going at it, the end is near! I look forward to more of your brainy questions…

• vincentt
Participant
• CFA Level 3
4

@diya but u have covered all topics in terms of going through once?

• 3

Deferred tax is a non-cash item so it has to be added back but according to the CFAI material. Adding/subtracting requires special attention because it is an caused by the difference in the timing of taxes and ideally will reverse. Therefore we should only be able to add it back if the company is growing and will be able to consistently defer taxes to a much later date but I digress.

The reason we add it back is because are looking at a “deferred taxes” figure opposed to a deferred liabilities or deferred assets. This is a netted total. For deferred taxes to decrease it means that the deferred liability has increased and therefore we will add it back.

Example:
2010
Deferred tax liability = 40
Deferred tax asset = 59
Total \$19

2011
Deferred tax liability = 42
Deferred tax asset = 59
Total = \$17

• 3

Yup @vincentt. No hard and fast rules though, as we know sometimes the wording twists in the questions can change things. But your general concept is right.

@fabian
, what @Diya says is right. @vincentt always asks the best questions – like this one that makes my hair shed – but I strangely love it! :))

• vincentt
Participant
• CFA Level 3
3

@diya i haven’t get the chance to do the proper mock yet, I would probably find out how tricky it may be when i start on it. Have u completed all the questions at the back of the reading in CFAI’s ?

@sophie
i guess for someone who isn’t from a financial background tends to ask odd questions. But i do appreciate your help in answering all my questions ðŸ˜€

• vincentt
Participant
• CFA Level 3
2

hi @diya , thanks for the explanation. Based on that sample question, DT is increasing every year hence I thought it’s right to deduct it as it looks like it’s a DTA (positive number) and i didn’t get it right in this case.

So just to confirm, if we are not expecting the DTA(DTL) to reverse in the near future we’ll deduct(add) it back to the NI.

However, if it does not mention anywhere about that (or company is growing), we’ll stick to the old rule which is to + NCC ?

• 2

I was gonna have a go at a response, then read up carefully on it and now I’m more confused.

Turns out I thought I understood it, but I was being thick and you guys are way further ahead of me in understanding…

• vincentt
Participant
• CFA Level 3
2

@fabian basically to calculate FCF (free cash flow) the formula is as follows:

FCFF = NI + NCC – WCInv + Int(1-T) – FCInv

What we are discussing right now is a focus into NCC. There are a few elements in them apart from the usual depreciation, for example, amortization (bond discount (add), bond premium(deduct) ), and obviously deferred tax asset/liability.

According to the syllabus, if the DTA/DTL is not reversible in the foreseeable future, you have to adjust it by deducting the DTA and add the DTL.

However, my question is to do with a sample question in schweser (Book 2, p355), since the “deferred tax” is increasing every year, wouldn’t it be right to deduct it (as it’s a DTA) or do we following the usual rule (add NCC) if there’s no mention of not reversible in the future?

As I’m a little confused when to think a step further and when not to over analyse.

• vincentt
Participant
• CFA Level 3
2

@sophie sorry for being a pain, doesn’t a positive deferred taxes means a DTA? which also means you have to deduct from NI ?

• 2

@fabian don’t get too discouraged. @vicentt’s questions are always very deep. I usually have to sit and think about the question and reflect – meditate on it before I can even come up with a half-decent response. On the bright side I’ll never forget this stuff!

• Zee Tan
Keymaster
• CFA Charterholder
2

@sophie Just hope that I’ll be like you in one of your blog post during the exam ðŸ˜›

• 2

@vincentt yea. But now I am going over it again and making notes of formula’s I didn’t remember and information that might be important. I’ve been also working out questions at random because sometimes I know the formula but get confused if the question isn’t straight and they throw a curve ball…

• vincentt
Participant
• CFA Level 3
1

@sophie I hope so too! 42 days to go which is exactly 6 weeks.

@zee
there can only be one survivor (in this case it’s either me or the exam) ðŸ˜€