Why FCFF Adds Back After-Tax Interest Expense
Summary
The exchange explains the positive interest term in the free cash flow to firm calculation. Net income has already been reduced by interest expense, so FCFF adds back after-tax interest to remove the effect of financing choices and estimate cash flow available to all capital providers. The explanation also offers EBIT after tax as an equivalent starting point that can be easier to remember.
The added-back amount reflects the tax shield associated with deductible interest under the tax treatment described in the discussion. This is not a sign convention for cash interest receipts: it addresses interest expense already deducted in arriving at net income. The exchange provides a conceptual reconciliation rather than a worked valuation, and its tax-shield explanation assumes the stated tax treatment applies; actual tax rules and the treatment of interest income can differ by context.
Key ideas
- Net income has already deducted interest expense when FCFF starts from net income.
- FCFF adds back after-tax interest to abstract from the company’s financing mix.
- EBIT after tax is an equivalent starting point for the same calculation.
- The tax shield explains why the after-tax interest add-back is positive.
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Full text
# Is "interest" positive or negative in the "free cash flow to firm" model? # Is "interest" positive or negative in the "free cash flow to firm" model? FCFF = net income + non-cash charges + interest x (1 - tax rate) - long-term investments - investments in working capital My intuition is: if the company is receiving interests payments, then the term "interest" is positive. If the company is paying out interests, the the term should be negative. Could you please clarify this for me? ## Answer by Leigh (score 2) https://quant.stackexchange.com/a/34507 - I would use EBIT*(1-T) instead of [Net Income + Int*(1-T)] (easier to remember), though they are =. - The sign is in fact positive since it provides a tax shield. - Also, the sign is positive b/c investors are only worried about a companies FCF, irrespective of financing decisions. One company might pay all cash, where as another might use 90% Debt. ## Answer by nbbo2 (score 0) https://quant.stackexchange.com/a/34529 In the calculation of Net Income by the accountants, the interest payments made by the firm have already been subtracted. Now, in this formula, we calculate FCFF by ADDING BACK to net income a portion of the interest, namely, the Tax Shield. You can think of "interest x (1-Tax Rate)" as the subsidy that the company received from the federal government because the tax code favors debt financing over other kinds of financing.
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