Levered vs. Unlevered Free Cash Flow Difference

does FCFF ALWAYS result in a higher number when compared to FCFE? or in which cases does not?

cmonkey711:

...as a private equity investor, your focus is on the cash flows you receive as an equity investor, since the creditors have to get paid before you receive anything.

wrong. as a PE investor you want unlevered free cash flow because you want to know how much cash is available for debt payment.

they aren't cash expenses, so while they lower your Net Income, they don't affect the amount of cash on hand

D&A are non-cash expenses. Depreciating something has no effect on cash flow, so you add it back. Cash flows when you buy the assets you're depreciating in the first place, which is why capex is subtracted (since it's a cash outflow and isn't accounted for as such in arriving at EBIT).

Well to complete the question... The reason you add back depreciation is because you deducted it out of EBITDA to get EBIT and then cash taxes that will be paid out, as depreciation lowers your taxes owed. However, the deduction doesn't account for an outflow of cash, and as mentioned above is added back to account for that, reflecting a higher free cash flow figure.

thanks guys

Depreciation is also management bias. With estimates regarding salvage value/life of assets/writedowns etc.

2) Usually, you take the unlevered beta of the industry, then you releverage this beta using the leverage of the company // Bu * (1+(1-T)*D/E)) 3) I don't know for sure but I'd would say that equity holders are exposed to the level of debt (the higher the debt, the greater the risk, which has an impact of the cost of equity). So to my opinion, you have to use a beta levered.

After all, the main difference in discounting FCFF vs. FCFE is that you're using the WACC in FCFF and the cost of equity in FCFE. CAPM method and key metrics shouldn't change.

Hope it helps.

Am I right that in this powerpoint it says to use unleveled beta for CAPM for FCFE http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/fcfe.pdf

True. But the shareholders will expect a higher return if the company has a great amount of debt. It'll have an impact on your valuation. So I don't think you can determine your cost of equity without taking into account the capital structure...

Wait for other comments.

3) I believe you are correct. The levered beta is what you pull from the market, and the market takes into account capital structure; you would therefore have to delever it and use that now unlevered beta to determine your cost of equity with CAPM.

Btw, the FCFE based method is no longer used at my firm... (don't ask me why neither the name of my bank)

Biotech valuations are more complex is this true biotech or genetic medicine/large molecule meds?

generally, if you have negative fcf, it's recommended to use other valuation approach (ddm, multiples)

revenue multiples would be helpful for most companies with negative fcf. i wouldn't skip over doing a dcf though, you could look at a greenfield approach DCF.

you have to project out to the point where fcf becomes positive... can take 10 - 15 year projection periods at times but either way, you can discount the negative cash flows and sum them up to get the pv of the future cash flows. the reason you have to project out until the company becomes profitable is so you can estimate terminal value based on a multiple or perpetuity growth

really? i thought that was how it could be done. i literally asked the exact same question to a finance professor the other day and that is the answer he gave me.

if fcf is negative you should use other methods of valuation... 10-15 years is way too far in the future to project out

I've seen an 18-year DCF for an alternate energy company before, so it certainly can be done, but as noted before... if you're looking at a company from a more traditional industry, once you get beyond 5-7 years, your already unlikely assumptions just become totally unrealistic. Aside from the difficulty in predicting the company's performance, you have to start seriously considering a lot of outside influences and it just becomes outrageous.

Best bet is to use a multiples-based approach. As noted above, you'll likely have to look at revenue multiples (guessing EBITDA is negative and won't be sufficiently positive for another 3-4 years). A DCF doesn't make much sense in this situation.

Agreed with being able to do long term DCFs. I have worked on many of these (often 15+ years) which have been presented to Biotech management / Boards (comprised of mgmt from publicly traded profitable companies / VCs) which have never questioned validity of methodology but rather specific underlying assumptions (discount rate / time to approval etc.) for the analysis while conceding there is an element of art to valuation - and values can get crazy. One of the underlying assumptions should be to POS (probability of success) adjust your cash flows i.e. there is plenty of literature around success rates for CNS/Oncology etc. drugs going from Pre-Clinical to Approval, Phase I to approval etc. and while timing through the FDA is never certain, it can be ballparked within reason. You also need to make sure you are discounting corporate overhead, NOLs, and we usually excluded cash (cash drives current value (development) of the assets). Many of these companies have zero revenue, and may have some milestone payments in the future (i.e. $xmm upon successful Phase II etc.) which should be factored in.

Any valuation needs to be compared to other methods, and I also agree using multiples (we rarely used revenue multiples) but rather a discounted P/E comparing the company being valued to other biotechs with a similar products focus (i.e. CNS/Oncology etc.) who are profitable. If for example Company A is the company being valued and it has a Oncology drug coming online in 2014, and Company Z is a current commercial stage Oncology company with an oncology focus, you would apply Company Z's 2011 multiple to Company A's fully-taxed POS adjusted earnings for 2015/2016 (whenever normalized sales hit) and discount that back to get a PV of the equity.

While recognizing limitations on all of these (DCF assumptions after a few years; problematic to assign discounted multiples - i.e. how do you find a multiple for a wonder drug company that has no peers?) they are recognized in the biotech / VC / Pharma communities and are used in-tandem to reach a valuation point. I have never been in a meeting with management or a board where they have completely dismissed the DCF.

it is called the vault guides....

correct me if I'm wrong, but I believe UCF = FCF

While LCF = UCF - (1-t)rD

where t = taxes; r = interest rate on debt and D = amount of debt.

As seen in the equation, the difference between UCF and LCF is that LCF takes out the after tax interest payment.

UCF is used in WACC and APV as it is the CF available to all financiers (ie it doesnt take out payments to debt financiers). Therefore, it will give you EV

LCF shouldnt be used in WACC or APV, but FTE, and will give you the value of equity holdings.

Of course, if you are dealing with an all equity firm, it doesn't matter if you use LCF and UCF.

I will check myself later, but funny thing is I don't actually see you helping him. Instead of arguing with me maybe you should actually do what you fucking preach.

ufcf= fcf + interest expense fcf=ni+dep. and amor.+deferred taxes-capex-inc. in nwc

For fcf, I always used

EBIT*(1-t) instead of NI. In which case, UCF = FCF

Because in a levered DCF you're also taking into consideration the effect of adding (paying down) new (existing) debt in calculating FCF. Also, in a levered DCF, you start out with Net Income while in an unlevered one you start with NOPAT.

I could be mistaken but aren't "Free Cash Flow to Equity" and "Levered Free Cash Flow" different things?

If you want to apply the dcf methodology to FCFE to calculate equity value, you would need to adjust the discount factor. Since you are using FCFE, you discount with only the cost of equity not the WACC.

Free Cash Flow to Equity (FCFE) = Net Income - (Capital Expenditures - Depreciation) - (Change in Non-cash Working Capital) + (New Debt Issued - Debt Repayments)

discounted at CoE, because you are not considering the debt effect on your cash flows.

this might help: http://people.stern.nyu.edu/adamodar/pdfiles/valn2ed/ch14.pdf

I don't know the answer but I will think about it this way: we are basically comparing the NPV of the saved debt payments vs. the net debt.

So if net debt is $100mm is that suppose to equal to the NPV? Assuming we have $0 cash, 40% tax rate, and a 10% interest rate. $6mm of cash saved each year discounted by 10%*(1-tax rate) equal to $100mm. So if it is a interest-only loan then the NPV will equal to total debt (assuming discount rate equals interest rate).

Therefore, there are two reasons for them to be different. 1.) we are discounting the cashflow with WACC, which is different than the interest rate 2.) principal payment will decrease the NPV further which decrease the equity value further

Just thinking out loud here

Hi,

First of all, you will have different results because of the leveraged CF. The discount rate is not the only important factor, you would have to consider the effect of leverage (even if minimal) when you compute your FCF.

Hope this helps!

Cheers

You can use either, it gives a range of where your projected intrinsic value should lie around within your DCF. This is also a common interview question that piggy backs off of this concept. FCFF gives you the cash flows entitled to all both debt and equity holders (which is why your exit multiple could be Enterprise Value/EBITDA). And FCFE is the cash flows entitled to solely equity holders (your exit multiple would have to be based on an equity value metric). The common metric used is FCFF because it is capital structure neutral.

Think about it this way, unlevered beta is the risk of the asset (business risk and operating leverage). Levering it accounts for any risk from debt in the business (remember equity is always junior to debt). More debt relative to equity means more CFs to debtholders before equity holders get their cash.

In regards to 1), You still use levered beta when constructing DCFs using Unlevered FCFs/FCFF in the CAPM in the WACC calculation. Remember you're now looking at all CFS available to the firm, thus your taking into account all CFs available to debt and equity holders. So, you still have to account for the fact that more debt means more CFs to debtholders before equityholders. So, you calculate this risk by using the cost of equity (calculated from CAPM) and debt weighted by their proportions in the capital structure.

You would use the unlevered beta for something like an Adjusted Present Value Model. This is where you look at a company as if it had a capital structure with 100% equity and then you add back the tax benefits of interest payments on debt while factoring in the cost and probability of bankruptcy.

Thank you very much! That was very helpful

it's minus change in WC so if the change in WC is negative, it's essentially adding WC. Didn't look at the attachment but I am assuming that's what is tripping you up.

Can't see the picture, but: EBITDA (16.2) + WC (4.3) - Capex (1.7) - Purchase of intangible (0.5) - Tax (2.6) + Deferred tax (0.5) + SBC (1.9) =18.0?

First way doesn't seem right, you've got to subtract d&a to get your real 'unlevered' tax.

Ideally, you want unlevered cash taxes paid: tax expense on the income statement + change in deferred tax assets + change in tax receivable - change in tax payable + Interest tax shields (interest expense * marginal tax rate).

Most of the times you will find a note 'cash taxes paid' in the financial statements, you just have to add interest tax shields to it.

Ok a bit of research here: Macabus says you need to tax EBITA http://macabacus.com/valuation/dcf/unlevered-fcf I Banking book by Rosenbaum says you need to tax EBIT My banker friend also said EBIT

Is this basically one of those grey areas?

You use EBIT. You are calculating FREE CASH FLOW and need to add back D&A because they are Non-Cash Expenses. However, you do not want them to be affected by the Tax Rate (as Interest and Taxes are Cash Expenses) and should therefore not use EBITDA in your calculation.

I was always under the impression that you find income taxes from EBT and then just subtract that value (also just found on the income statement) from EBITDA to get EBIAT. Then you get UFCF from EBIAT-CAPEX-Change NWC. Is that not right? Assuming you use the same value of income taxes from the income statement, both the formulas OP listed are the same.

You are making this way too complicated. You can calculate FCFF from any starting point if you understand how it's derived. To illustrate what I mean assume:

EBITDA = 100 D&A = 20 Tax rate = 20%

Therefore EBIT(1-t) = 64 EBIT + D&A = 84.

EBITDA (1-t) = 80

Then add back taxes saved due to depreciation : D&A (t) = 20 x 0.2 = 4

Therefore 80 + 4 = 84 as above

Thanks guys:)

You don't. It's a financing transaction. Moreover, it's the FCF that allows the dividend to be paid...dividends are paid out of FCF.