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Hello John,
I am very confused with Free Cash Flow calculation in the investment appraisal (NPV) vs. Free Cash Flow to Equity calculation for dividend capacity as well as APV vs Free Cash Flow to Equity. When it comes to the free cash flow calculation, in the cash flow calculation of the investment appraisal the interest is irrelevant, whereas in FCFE it is not. Similary, in some calculations tax allowable depreciation can be deducted and in others, like in the dividend capacity calculation for example (like in the Arthuro Co question of the March / June 2018 exam) it is not?!
Thanks a lot, I really appreciate your help!
Best regards,
MargaritaDiscounting the free cash flow at the WACC gives the total value of the company (equity plus debt), and interest is not relevant (because it is taken into account in the calculation of the WACC).
Discounting the free cash flow to equity at the cost of equity gives the value of the equity and interest is relevant because it reduces the amount available for the equity.
Tax allowable depreciation is not a cash flow which is why it is added back, unless (as I explain in my free lectures) the question states that an amount equal to the depreciation is invested each year in maintaining the assets (which is something the current examiner often states in questions).
Thanks a lot, John!
And another question in this context… It’s understandable why depreciation on non-current assets has to be added back as it is a non-cash item. But I thought that tax deductible depreciation is a tax allowance so to say, which reduces the profits and therefore taxes to be paid. But in this case I would have more cash in total. So why is the tax deductible depreciation a non-cash item and has to be added back? Aren’t these two different things?Thanks for clarification!
Best regards,
MargaritaThe TAD is subtracted when calculating the tax payable (and the tax is a cash flow). However because the TAD itself is not a cash flow then if it has been subtracted for the calculation of the tax then it then needs to be added back (because it is not a cash outflow).
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