Equity Valuation

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krishna11

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CFAI Book on Equity - Volume 4, Question 1, Page No. 328
I could not understand the effect of $100 Changes in Interest Expense and its effect on FCFF (0) and FCFE (-60). Any clue?
I could not understand the effect of $100 Changes in Notes Payable and its effect on FCFF (0) and FCFE (+100). Any insight?
Thanks in advance.
KK
 
Re interest expense. FCFF measures cash flow before debt and equity holders are compensated. so an increase in interest expense won’t affect it. it will reduce FCFE though (because that measures the cash flow left for equity holders after debt holders have been paid).
Re notes payable. FCFF isn’t affected by borrowing. but FCFE is (because the money from the new borrowing is available for the equity holders). Neither are affected by adding extra equity to the company.
So in summary. changes to debt (eg new borrowing, debt repayments, or interest payments) don’t affect FCFF but do affect FCFE.
Changes to equity (share sales, repurchases, dividends) don’t affect either FCFF or FCFE.
 
In this question the tax rate is 40%.
If you look at the formula for FCFF through NI it is
NI + NCC + Int(1-tax) - FCInv - WCInv
Since the Interest is removed from EBIT to reach to NI, it is added back as FCFF is free cash flow available to both debt & equity holders. Therefore increase in interest rate would have no impact on FCFF
FCFE = FCFF - Int (1-tax) + NB
After tax interest would be 60 and FCFE will fall with this amount if interest increases $100.
Notes payable are included in NB (Net Borrowings) and they only affect FCFE not FCFF.
 
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