So the title is basically my question. We use the WACC to discount the FCF and I do not completely understand why we are using something levered to discount something unlevered!
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Well, free cash flow should correspond with your discount rate.
If you use a levered free cash flow value (with interest expense subtracted) you are effectively calculating an equity value with a DCF model, and so discount rate is just cost of equity (all other forms of capital don't matter).
If you use an unlevered free cash flow value (with interest expense included) you are effectively calculating an enterprise value with a DCF model, and so discount rate is what you call "WACC", or cost of debt, equity, and other forms of capital.
Hold on, levered free cash flow's interest expense is subtracted? I'm pretty sure that's unlevered free cash flow since the effect of interest is taken out of consideration and thus no leverage. I could be wrong but if that's the case then neither of my boss and my professors spotted out in my DCF models
Sorry for the confusion, and you are correct. It has more to do with my wording than the theory - if our unlevered FCF is 100 and interest expense is 10 our levered FCF is 90. That's what I meant.
I think you're mixing up the concept of a levered beta and a levered cash flow (I'd suggest reading into the differences between the two).
For the purpose of a "traditional" DCF that uses FCFF(unlevered) and WACC, the output is enterprise value as it captures the value of both debt and equity stakeholders within the company. The levered beta is used to calculate the cost of equity, however by adding the proportion of debt to the WACC calculation, its representative of both.
I would think of it another way entirely:
DCF is used to calculate the value of invested capital That invested capital can take many forms (sr debt, unsec debt, converts, equity) with varying risk profiles and weightings We use public company securities to approximate the sector average expected return (WACC) on that invested capital Because of the different funding weightings across companies your comps universe you must assess the expected return before interest has been deducted from cash flow (i.e. unlevered cash flow)
unlevered fcf = cash flow to equity and debt holders so you discount at weighted avg of cost of equity and cost of debt
levered fcf = cash flow to equity holders only so you discount at cost of equity
Best answer
WACC is based on the components of the cap structure. You have to account for the full risk to the equity, using a levered risk factor (beta). Cash flows are taking into account the cash value to the whole firm whereas WACC looks at total risk, and typically as a going concern.
Unlevered FCF Confusion (Originally Posted: 11/23/2016)
WRT Unlevered free cash flow (cash that should conceptually be available to creditors as well as equity) why do we (1) use EBIT - which adds back NET interest expense and (2) Apply Taxes to EBIT? If these cash flow are to be truly representative of cash flows to creditors as well as investors, then isn't it true that (1) payments to creditors could be satisfied out of interest revenues and (2) creditor claims could be satisfied before the application of taxes?
UFCF is the core cash flow available to creditors and equity holders. You subtract taxes because you need to pay them anyway and you do not subtract the net interest expense (income) because you wanna see how much cash is available to pay creditors first and then equity holders.
Hi Masters, thanks for the expedited reply. I think that I didn't make myself fully clear. WRT net interest expense, I am specifically confused as to why interest revenue would be subtracted from UFCF - recall, by adding net interest expense, we effectively subtract interest revenue. Shouldn't interest revenue be available to creditors? Wrt taxes, don't creditors have claims over the government (ie, since taxes are calculated after interest has been paid, isn't it true that cash flows to creditors shouldn't be modified downward for taxes)? Thanks again!
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