Tax Shield and its Impact on Equity Holder Returns

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In the last chapter, we discovered that we could find the Free cash flow to the firm by adding back in non-cash expenses to Profit after taxes. These expenses included:

Depreciation

Amortization

Deferred taxes

Proceeds from the sale of assets

Tax Shield equity return

Interest expense

Including the interest charge can be challenging, so we should take the time to comprehend how to put it in. To exemplify this, consider this example –

We can observe from the company’s bottom line P&L that their EBIT is 700 Cr with interest charges of 70Cr at 10%. Subsequently, their PBT equals 630 Cr and after a 25% tax rate, taxes amount to 157.5Cr. Ultimately, that brings us to their final PAT = 472.5 Cr which is arrived at by subtracting Taxes from PAT.

To calculate the Free cash flow to the firm, we begin with PAT and add back non-cash expenses. Also, we include the interest paid to demonstrate that it goes to the debt holder. Doing this should –

Tax Shield equity return

PAT = 472.5

(Add) Interest = 70

= 542.5

When we pay interest, the tax outflow decreases. For example, the tax rate here amounts to 157.5 Cr while the total interest paid is 70. If we consider the interest as 0, it would make PBT 700 and with a 25% tax rate, the outflow of taxation rises to 175.

Tax Shield equity return

The addition of interest should be taken into account for tax protection. To ensure this,

Interest (with tax shield) = Interest *(1 – tax)

= 70*(1-25%)

52.5

So when you add back interest to PAT to calculate the FCFF, we add 52.5 here and not 70. In this example –

PAT = 472.5

Interest = 52.5

525

To refresh your understanding, FCFF calculation requires…

FCFF = PAT + Depreciation + Amortization + Interest*(1-tax rate) + deferred taxes – working capital changes – investment in fixed assets (CAPEX).

We can start the FCFF calculation either with PAT or EBIT. If we choose to begin with EBIT, we must include the tax shield in our calculation.

FCFF = EBIT *(1-tax rate) + Depreciation + Amortization + deferred taxes – working capital changes – investment in fixed assets (CAPEX).

For our example, let’s use the equation provided above to determine the result.

= 700*(1-25%)

= 525

Omitting non-cash expenses, CAPEX, and working capital fluctuations makes keeping things simple. What matters most is that the FCFF figure will be consistent whether you begin with PAT or EBIT.

You can ascertain the free cash flow to the equity holders by subtracting the net debt from the free cash flow to the firm.

Free Cash flow to Equity = FCFF + [Debt – Principal repayment]

Where, [Debt – Principal repayment] = Net debt

Hence,

Free Cash flow to Equity = FCFF + Net debt

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