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

How would the following items affect FCFF?

  • This topic has 7 replies, 5 voices, and was last updated Oct-17 by ykilstein.
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    • vincentt
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      The question is:

      Assuming a FCFF figure for year 1 is £1m, for the items below calculate how a £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

      Answer:
      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?

    • fabian
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      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 £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 £200k, but NI would decrease by £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

      So adding your 200k increase to depreciation, you get

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

    • MattyJ
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      What he said.

    • Zee Tan
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      What he said.

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

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

    • fabian
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      Thanks @mattjuniper! 😀

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

    • ykilstein
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      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…)

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