Chartered Financial Analyst (CFA) Level 1 Practice Exam

Why is the tax rate applied to interest expense in the FCFF calculation?

1. To reflect the tax shield on debt

2. To determine the profitability of the firm

3. To adjust cash flow for inflation

4. To normalize cash flow across different firms

The correct answer is: To reflect the tax shield on debt

In the calculation of Free Cash Flow to the Firm (FCFF), applying the tax rate to interest expense is essential because it accounts for the tax shield that debt financing provides. When a company incurs interest expenses, these expenses are tax-deductible, effectively reducing the taxable income of the firm. This tax deductibility creates a benefit, often referred to as the "tax shield," because it allows the company to save on cash taxes. By reducing the total tax burden through the deduction of interest expenses, the overall cash flow available to the firm is increased. When calculating FCFF, which represents the cash available to all investors (both equity and debt holders), it is important to reflect this reality through the application of the tax rate to interest expense. This approach accurately represents the effective cash flows generated by the firm's operations after considering the costs of debt. The other choices do not align with the specific purpose of applying the tax rate in FCFF calculations. For example, determining the profitability of the firm does not directly relate to interest expense, adjusting for inflation pertains to a different aspect of financial analysis, and normalizing cash flow across different firms is not specifically relevant to the treatment of interest and tax in FCFF calculations.