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
© 2021 BP Equities Pvt. Ltd.
All Rights Reserved
By signing up, you agree to receive transactional messages on WhatsApp. You may also receive a call from a BP Wealth representative to help you with the account opening process
Disclosures and Disclaimer: Investment in securities markets are subject to market risks; please read all the related documents carefully before investing. The securities quoted are exemplary and are not recommendatory. Past performance is not indicative of future results. Details provided in the above newsletter are for educational purposes and should not be construed as investment advice by BP Equities Pvt. Ltd. Investors should consult their investment advisor before making any investment decision. BP Equities Pvt Ltd – SEBI Regn No: INZ000176539 (BSE/NSE), IN-DP-CDSL-183-2002 (CDSL), INH000000974 (Research Analyst), CIN: U45200MH1994PTC081564. Please ensure you carefully read the Risk Disclosure Document as prescribed by SEBI | ICF
Attention Investors
Issued in the interest of Investors
Communications: When You use the Website or send emails or other data, information or communication to us, You agree and understand that You are communicating with Us through electronic records and You consent to receive communications via electronic records from Us periodically and as and when required. We may communicate with you by email or by such other mode of communication, electronic or otherwise.
Investor Alert:
BP Equities Pvt Ltd – SEBI Regn No: INZ000176539 (BSE/NSE), INZ000030431 (MCX/NCDEX), IN-DP-CDSL-183-2002 (CDSL),
INH000000974 (Research Analyst) CIN: U45200MH1994PTC081564
BP Comtrade Pvt Ltd – SEBI Regn No: INZ000030431 CIN: U45200MH1994PTC081564
For complaints, send email on investor@bpwealth.com
