Leverage impact on FCFF and FCFE

[andrevc]

All,
On Schweser book 3, P149 they say that leverage have small impacts on FCFE but no impact on FCFF. Why is that?
Doesnt the level of debt impact how much interest the company will be paying (impacting after-tax interest expense) and thus impacting FCFF as well?

 

[CatFancierAnalyst]

From another thread
JJ1337
Apr 9th, 2014 11:06am

• Germany
• CFA Charterholder
• 376 AF Points

FCFF is the cash flow available to all capital providers, i.e. equityholders and debtholders. If the leverage changes it is not relevant for FCFF, ‘cause only the allocation of FCFF between equityholders and debtholders changes.
FCFE is somewhat different. For example, leverage change ‘cause the firm borrows. In that year FCFE will be higher, because net borrowings increase. In the following year FCFE will be somewhat lower, because the interest payments increase due to the new loan.
Keep in mind: FCFE = FCFF - Int x (1 - tax rate) + net borrowings

 

[S2000magician]

Recall that for FCFF you add back interest net of taxes: the impact of interest on FCFF is zero.

 

[andrevc]

I don`t get it. If you add back interest net of taxes and leverage is higher (so interest is higher) how can it no affect FCFF?

 

[andrevc]

Ok got it now. It’s more complicated than what it seems.
What happens is: considering the formula for FCFF starting with NI:
FCFF = NI + NCC + Int(1-tax) - chg FCinv - chg WCinv
When we increase leverage, the term Int (1-tax) increases, but its exactly offset by a decrease in earnings of the same size, so FCFF remains unchanged.
However, there is a change in weights of capital for the WACC calculation, so if we are increasing leverage, WACC will likely fall (considering Kd < Ke) and thus firm value will go up.

 

[S2000magician]

That’s correct: interest net of taxes is subtracted within net income, then added back for FCFF.
And yes: if the capital structure changes and WACC drops, the firm value will increase. You’ll get a dose of that at Level II.