Debt issuance and its impacts on FCFF FCFE

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jaychou

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I got this answer from Schweser but i doubt its correct. They said new debt issuance will NOT have any impact on FCFF but will increase FCFE in early yrs then reduce FCFE inlater yrs due to int expense. In my understanding, the proceeds from new debt issuance will belong to the firm, not shs holders i.e. it will increase FCFF, no impact on FCFE. Furthermore, i see that FCFF= NI + ncc+ int expense(1-t) -wcinv - fcin while in the FCFE equation using NI, int expense is absent. Am i right or i misunderstood Schweser???
 
You are wrong with your understanding of FCFE - think of that debt issuance as capital available to equity holders for use (Therefore you add any net new debt and subtract any net repayments). Interesting fact with respect to the impact of debt on FCFE in later years due to int expense, i didnt see that in the CFAI texts.
 
Thanks for the heads up but can u explain to me why the FCFF has int(1-t) in it and issue new debt is not gonna have an impact on FCFF? Obviously int expense will increase, which in turn provide tax savings which increase FCFF
 
I think it would be best for the magician to answer this question but ill give it a try too. Your latter statement
Obviously int expense will increase, which in turn provide tax savings which increase FCFF”
is correct, and therefore FCFF will already account for that new tax saving.
 
Hmm ok lets hope he drives his S2000 by this thread
 
FCFE = FCFF - int(1-t) + NET BORROWINGS
FCFF by definition is Cash Flow Available to the Firm, and this is what gives value to the firm. Any cash raised from borrowings or equity does not add value to the firm. It is when you invest that cash (WCInv and FCInv) and it generates greater cash through operations (CFO) does it add value to the firm.
With regards to FCFE, more debt = more interest cost. By debt issuance you increase cash from borrowings by more than the amount of the interest expense generated (obviously) yes… but the more you borrow the higher the interest expense. and during the years you dont borrow (no cash inflow to net borrowing) you are only left with loads of interest expense in calculating FCFE from FCFF.
 
I have only six hands.
Net borrowing doesn’t affect FCFF because FCFF is measuring cash flow generated by the business; borrowing isn’t generated by the business, and its net effect is zero (the business borrows it, the business has to pay it back).
Net borrowing does affect FCFE because that’s cash that could be given to the shareholders if management wanted to. Not a good idea, perhaps, but a possible one. Note that, unlike the firm, which has to pay back the borrowing, equity doesn’t have to pay back the borrowing; it’s assumed that it will be paid back by cash flow generated by operations.
Thus, the day that you borrow money, it’s all available to equity, so FCFE increases.
Alas, the firm has to make coupon payments to the bondholders. The good news is that the government loves the firm, and pays part of that coupon for them (lower taxes). Unfortunately, when that cash (net of taxes) goes to the bondholders, the stockholders cannot get their hands on it, so it lowers FCFE (in the years after the money was borrowed). And, of course, when the bonds are paid off, that cash flow also lowers FCFE (it’s included in “net borrowing” as a negative number).
I think that that’s it.
May I go back to my Caol Ila now?
 
I think he is referring to question #39 in Schweser Book 2, Exam 2 (AM).
I understand what you are saying S2000, but if the firm borrows $100 more in debt at 6%, won’t that increase the interest tax shield, and in turn increase FCFF by that 6(1-t) amount? What would be the offset?
 
FCFF = NI + … + int(1 - t) + …
Net income is reduced by interest expense (net of taxes), and FCFF adds back interest expense (net of taxes); seems like a wash.
 
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