Why not to include interest expenses in a DCF's unlevered FCF
Hi,
so far I had two explanations in mind in case s/o would ask me why to exclude interest expenses from calculating unlevered FCF in a DCF.
1.) In a DCF we project FCF and a terminal value which we then discount at the weighted average of the companies cost of capital to receive an estimate for EV. As EV is relating to both equity- and debt-hodlers, we have to use a FCF that excludes interest expense.
2.) The projected FCFs will be discounted using WACC, which already reflects the after-tax benefits of borrowing (WACC utilizes after-tax cost of debt in its calculation).
Any thoughts on which one to choose over the other?
1 sounds better. You are calculating the free cash flows that are available to all investors. Likewise if you just wanted equity value you would use the free cash flows after the interest expense and discount by just the cost of equity.
Wouldn't the explanation be that because you are trying to find cash flows exclusive of the company's current capital structure (for comparison purposes), you don't include interest because it is an expense that results from a percentage of the cap structure being debt, which you are effectively controlling for in finding UFCF?
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