<p>Debt service cost is felt by equity owners and debt holders but neutral to the firm. Taxation does not care for cash flow, it is levied on tax law specific accounting profit, not even reporting profit, which tends to treat most interest charges (not all and not uniformly either) as a deductible cost. Thus you make an adjustment to your WACC as you said. However, interest charge does not need to be uniform during the life of the debt. Unless you do your WACC adjustment for every period and apply a different WACC for each (you should always at least justify not doing so anyway), you will end up with a inflated cash flow and higher discount rates. </p>

CC BY-SA 3.0
2017-06-09T21:28:27.557Z
2017-06-09T21:28:27.557Z
user110084
<p>I've got this question:</p>

<blockquote>
  <p>Explain why the FCFF does not incorporate interest expenses and what is the potential bias in the valuation if corporate taxes exist.</p>
</blockquote>

<p>Now, we know that in the Free Cash Flow to the Firm we do not include interests because we account for the cost of debt capital in the discount rate. But what is the bias when corporate taxes exist? The flows are computed after-taxes, and then discounted. Maybe can emerge a problem when computing the tax shield, but this is easily tackled by using either Weighted Average Cost of Capital (if the project's flows have the same risk of the firm, and the firm keeps constantly the Debt/Value rate constant) or by using Adjusted Present Value when the debt ratio changes during the lifetime of the project. </p>

<p>Any suggestions?</p>

<taxation><corporate-finance>
Free Cash Flow to the Firm
james42
# Free Cash Flow to the Firm

(Asked by: username_0 on 2015-07-08)

I've got this question:

> Explain why the FCFF does not incorporate interest expenses and what is the potential bias in the valuation if corporate taxes exist.

Now, we know that in the Free Cash Flow to the Firm we do not include interests because we account for the cost of debt capital in the discount rate. But what is the bias when corporate taxes exist? The flows are computed after-taxes, and then discounted. Maybe can emerge a problem when computing the tax shield, but this is easily tackled by using either Weighted Average Cost of Capital (if the project's flows have the same risk of the firm, and the firm keeps constantly the Debt/Value rate constant) or by using Adjusted Present Value when the debt ratio changes during the lifetime of the project.

Any suggestions?

**Tags:** taxation, corporate-finance

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## 1 answers

### Answer by username_1 on 2017-06-09. Score: 2 | Accepted answer

Debt service cost is felt by equity owners and debt holders but neutral to the firm. Taxation does not care for cash flow, it is levied on tax law specific accounting profit, not even reporting profit, which tends to treat most interest charges (not all and not uniformly either) as a deductible cost. Thus you make an adjustment to your WACC as you said. However, interest charge does not need to be uniform during the life of the debt. Unless you do your WACC adjustment for every period and apply a different WACC for each (you should always at least justify not doing so anyway), you will end up with a inflated cash flow and higher discount rates.


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