Why is Depreciation added back in the FCFF formula?

Why is Depreciation added back in the FCFF formula?

• A. Because it increases cash flow.
• B. Because it is a non-cash charge that reduces tax but does not require cash outflow.
• C. Because it is a financing cash outflow.
• D. Because it is only an accounting adjustment for depreciation.

Answer: (B)

Depreciation is a non-cash expense that lowers the reported profit but doesn’t actually use cash in the period, so in FCFF we add it back to reflect the true cash generated by operations. It reduces taxable income (giving a tax shield), but that tax effect is already captured when you compute after-tax operating income as EBIT times (1−Tax rate). To convert that after-tax profit into cash, you add back the depreciation since no cash was spent on it. This approach keeps FCFF focused on cash available to all capital providers, not on accounting charges.

Depreciation is a non-cash expense that lowers the reported profit but doesn’t actually use cash in the period, so in FCFF we add it back to reflect the true cash generated by operations. It reduces taxable income (giving a tax shield), but that tax effect is already captured when you compute after-tax operating income as EBIT times (1−Tax rate). To convert that after-tax profit into cash, you add back the depreciation since no cash was spent on it. This approach keeps FCFF focused on cash available to all capital providers, not on accounting charges.