LBO and Interest Expense
I am probably missing something here, but felt that there was a discrepancy between:
- When getting to free cash flow in, say, an LBO model, we subtract interest expense. Then we start with net income to make adjustments related to the cash flow statements to get to FCF.
- As I understand it, unlevered FCF uses NOPAT (EBIT after tax) before making those cash flow statement adjustments — the idea being to not include the effects of debt/interest.
How do these two fit together?
They are two different kind of FCF: 1) is "levered" and is the amount of cash your business generates after it has met its financial obligations - in the case of a healthy business with limited leverage, it gives you a good proxy of how much liquidity you are generating and could be used to further develop the business (acquisitions) or pay your debt in advance. 2) is "unlevered" and shows a different picture of your business: the cash it generates should it have no financial commitments (debt basically) - could be used for comparability purposes if your business is overlevered at one point in time and your LFCF is negative for example. You could think about it the same way we use EV / EBITDA or P/E ratios depending on what we want to show or the company's leverage situation.
1) is used to set up annual budgets (how much capital is available and what decision can be derived from this? Leveraging more, doing acquisitions...) / 2) to determine operating cash flow (what's left in my pocket once everything is paid)
And by the way the link between the two mathematically is: LFCF = UFCF - Interest (very basically)
Let me know if that's clear?
Just to add to the above, I personally think of LFCF as potential dividends - this is what the firm can afford to pay out to its shareholders. If it doesn't, it just accumulates in Cash & Marketable securities on the BS.
Also, very briefly, the formula the poster provided for LFCF is actually the formula for 'FCF available for debt paydown', not true LFCF, which is LFCF = UFCF - Interest (1-t) + Changes in Debt. You can discount these LFCF at the cost of equity to get your equity value. In the context of an LBO, this LFCF definition is not awfully helpful but the two terms (FCF avail. for debt paydown and LFCF) are distinct from one another but often are conflated to mean the same thing.
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