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ACCA Strategic Professional · Advanced Financial Management · Valuation and the use of free cash flows

When forecasting free cash flows to the firm for a valuation, which treatment of the tax shield on debt interest is consistent with discounting at WACC?

FCFF should exclude interest and the related tax saving, because the debt tax shield is already captured by using the after-tax cost of debt in WACC. Including it in the cash flows too would double count the benefit and overstate value.

  1. AExclude interest and its tax relief from the cash flows, because the tax shield is captured in the after-tax cost of debt within WACCCorrect
  2. BDeduct interest payments from the cash flows and discount at WACC
  3. CInclude the interest tax saving in the cash flows and also use an after-tax cost of debt
  4. DAdd back depreciation but deduct interest to reach FCFF

Explanation

FCFF is calculated before financing flows, with tax computed as if the firm had no debt. The tax benefit of debt is reflected in WACC through the after-tax cost of debt. Including it in cash flows as well would double count the benefit.

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