CFA CFA Level 2 How would the following items affect FCFF?

# How would the following items affect FCFF?

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• vincentt
Participant
• CFA Level 3
0

The question is:

Assuming a FCFF figure for year 1 is Â£1m, for the items below calculate how a Â£200k increase in each item below would impact on FCFF. Assume where relevant a tax rate of 20%.

1. Depreciation (assuming it is tax deductible)
2. Accounts receivables
3. Interest expense

1. +40k
2. -200k
3. no impact

I understand #2 and #3 but i couldn’t figure how the logic for #1.

I thought the formula for FCFF is NI + NCC(noncash charges e.g. depreciation) – WCInv + Int * (1-tax) – FCInv

So why was the increase only 40k and not 200k ?

Even if it’s ‘tax deductible’ shouldn’t it be +160k?

• 5

Isn’t FCFF actual cash flow? So any depreciation adjustments wouldn’t actually directly impact FCFF, but the tax savings it generates (assuming an increase in Â£200k in depreciation saves you 200*20%=40k) will be added to the FCFF.

In terms of explaining it via the formula, your NCC would increase by Â£200k, but NI would decrease by Â£200k as well, plus an increase of 40k in tax benefits. The better formula to use would be:

EBIT * (1-tax) + Depreciation & Amortization – WCInv – FCInv

(EBIT – 200k) * (1 – 20%) + (D&A + 200k) – WCInv – FCInv
= EBIT – 160k + (D&A + 200k) – WCInv – FCInv
= EBIT + D&A – WCInv – FCInv + 40k

• Zee Tan
Keymaster
• CFA Charterholder
4

What he said.

@mattjuniper no, you’re not picking up an easy badge that way!

• 4

Never mind, they’re not taxed. Just added.

We addressed this, but would deferred taxes come into play for FCF formulas in the equity section? (I think not…)

• 3

What he said.

• 3

Thanks @mattjuniper! ðŸ˜€

• 2

Would preferred dividends be taxed when adding to get FCFF, like interest?

• 0

@Zee Ha I wish! Actually I had nothing more to add. @Fabian covered it off beautifully!