Do Levered Free Cash flows and unlevered yield the same value? Why not?
Prepping right now and kind of confused as to why the answer for this is that they would in theory produce the same results. Leverage free cash flow includes the effect of interest expense and debt repayments. Even if capital structure stays constant overtime There would still be a varied answer because levered free cash flows were taken into account of interest expense and debt repayment, which would lower your levered free cash flows. So how is it possible that they can yield the same results not to mention that levered free cash flows are being discounted at cost of equity which is a higher discount rate. than your weighted average cost of capital
Based on the most helpful WSO content, levered and unlevered free cash flows do not yield the same value due to several key differences:
Interest Expense and Debt Repayments:
Discount Rates:
Capital Structure Impact:
In summary, the differences in how interest expenses, debt repayments, and discount rates are handled ensure that levered and unlevered free cash flows do not yield the same value. Levered free cash flows are lower due to the deduction of financial obligations and are discounted at a higher rate, reflecting the increased risk to equity investors.
Sources: Levered vs. Unlevered Free Cash Flow Difference, Free Cash Flow to Firm vs. Free Cash Flow to Equity Growth Rates, Walk me through a DCF, FCFF vs Unlevered FCF - is there a difference?, Why even use EBITDA?
If by result you are referring to Enterprise Value, then the reason is that discounting the sum of UFCF gives you enterprise value itself whilst discounting the sum of LFCF gives you Equity Value. If you add Net Debt to the equity value obtained from discounting the sum of LFCF, you should get the same enterprise value as obtained by discounting the sum of UFCF.
You’re right that in theory, both will yield the same results and you can - if you want to - make the two results balance for any DCF, but you need to make very consistent assumptions. And yes; although LFCF are burdened by interest expenses, increases in debt actually increase LFCF - it’s totally possible for LFCF to be higher than UFCF. Recall that in the WACC method, the firm follows a fixed leverage ratio (D/V), that means as the firm value grows (declines) it will borrow more (less) debt. To make the two approaches reconcile, you must take this into account.
To see this intuitively, going back to first principles, the value of the levered firm is equal to:
Equity + Debt = V (right hand side of the BS)
PV(Operating Assets) + PV (Tax Shields) = V (left hand side of the BS)
These are ‘fundamental’ equations and are always true.
When you value V with the WACC, you’re valuing cash flows to Operating Assets and discounting by WACC. In other words, the discount rate reflects the presence of tax shields already.
Alternatively, you could value E and D separately and then add them together to get the same V. Valuing E is discounting LFCF by the cost of equity, and valuing D is discounting interest expenses and principal repayments by the cost of debt (this is typically proxied by the book value of debt, but to make the two methods balance perfectly, you can no longer make this assumption).
The presence of tax shields in the E + D method is imbedded in the LFCF calculation, as you are subtracting interest payments after tax. And whilst yes, the cost of equity is higher, the cost of debt in the value of D is what allows both methods to be equal.
You can also google ‘Damodaran FCFF vs FCFE’ and download the Excel file that comes up, you can then play around with the numbers.
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