Does unlevered cash flow exclude interest?

ThreeDot's picture
Rank: Senior Monkey | 92

I've read two different interview guides (MI & WSO). One says Unlevered cash flow includes interest and the other say it excludes. which one is it?

Unlevered Cash Flow

The short answer is no, unlevered cash flow does not include interest. The name itself is a give-away. "Leverage" is a term that financiers use to indicate the use of debt. The prefix un meaning not.

esbanker - Private Equity Analyst:

unlevered FCF simply means looking at a company's cash flow before the effects of debt are taken into account (ie, CF to all the capital providers for a firm).

Semantics aside, how do we arrive at unlevered cash flow?

unlevered free cash flow calculation

Stringer Bell - Corporate Development Vice President:

Unlevered FCF is what's available to all providers of capital (i.e. debt, equity and hybrid capital). Including interest expense would negate the point of the metric. FCF that nets out the benefit to debt holders is FCF to Equity (CFO - investments in LT capital - debt pay down), so if you want FCFE then yes interest expense would be left in the calc via Net Income to CFO. Where you may be confused is if when you calculate FCF to all providers of capital (FCFF, or essentially Unlevered FCF) you need to adjust the Interest Expense add-back by removing the "tax-sheild" benefit (Interest Expense*(1-tax rate)). The above is applicable to calculating FCF from the Statement of Cash Flows.

Typically Unlevered FCF Calculation

  1. Operating income + Amortization of nondeductible goodwill: EBITA*(1-tax rate) aka NOPAT
  2. Add: D&A and other non-cash expenses affecting the above
  3. Add: Changes in deferred taxes
  4. Less: Capex and other investments in fixed capital
  5. Less: Increase in other non-cash working capital
  6. Arrive at Unlevered FCF

UFCF's "point" is to give an investor an idea of a company's or an asset's ability to pay interest or retire debt and / or pay a dividend or buy back stock to service equity holders. Therefore it wouldn't make much sense to include interest expense in your calculation.

It is important to understand how these concepts come into play in a DCF model. Likewise, to know how concepts such as this can impact the three financial statements. Mastering these subjects takes time and practice. If you are interested in continuing your self study, then follow the link below to get started.

Financial Modeling Training

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Comments (39)

Jan 24, 2012

Unlevered FCF is the cash flows produced by the company excluding any financing decisions, so naturally it would not include interest payments.

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Jan 24, 2012

One of the goals of unlevered cash flow is to show the world how the firm's cash flows look without servicing debt. You use unlevered cash flow (or free cash flows) to show the actual cash flow that is available to stakeholders of the firm. I will try to give a detailed answer below; however, I am very tired...

Interview acceptable answer:
1) Earnings before interest and taxes (EBIT) x (1-Tax Rate)
2) Add back any dep/amortization (non cash expenses)
3) Subtract any changes in NWC (CA-CL)
4) Subtract any capex
5) Arrive at FCF

1) Starting with EBIT...[Notice that this is earnings before interest and taxes...)
2) Add back in the amort of non-deductible goodwill
3) You now have EBITA
4) Use EBITA x tax rate to determine the taxes on EBITA
5) This gives you unlevered net income
6) Add back in non cash expenses (depreciation and amortization [note: you already added back goodwill amort]
7) Subtract changes in NWC
8) Subtract CapEx
9) Arrive at UFC

Edit: PTS got to it faster and better.

Jan 24, 2012

I think your confusion may be around "include" vs. "exclude" considering that interest is an expense. UnFCF excludes the "effect" of interest expense, meaning that you don't subtract it out as an expense. All of the reasons are above.

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Jan 24, 2012

It does not include interest income and/or expense

EBIT(1-t)

Earnings BEFORE taxes, interest

This means that interest is not included.

It doesn't matter if interest expense is $1 million or $1 billion, EBIT is unaffected.

Jan 24, 2012

all explanations above are spot on.

a good way to remember is the following:

leverage = debt
unlevered = no debt (so to speak)

so unlevered FCF simply means looking at a company's cash flow before the effects of debt are taken into account (ie, CF to all the capital providers for a firm).

cheers.

Jan 24, 2012

think of it this way:
levered = debt
UN-levered = no debt --> no interest expense deducted.

Jan 24, 2012

The more important question you need to be prepared for is: "Why would you want to look at unlevered vs. levered free cash flow?"

Any idiot can learn the difference in the formula.

I want the one that understands when unlevered FCF is applicable versus when levered FCF is applicable.

Take a shot on here. Much better to explore and learn now, before the interview.

Jan 24, 2012

Excludes interest. The only reason you may have seen a formula used to derive unlevered free cash flow would be if you start at e.g. net income to derive unlevered FCF (where you need to obviously add interest back).

Jan 24, 2012

I love the questions today. Unlevered cash flow means cash flow that is without leverage. IE no debt

Jan 24, 2012

I love the questions today. Unlevered cash flow means cash flow that is without leverage. IE no debt

Jan 24, 2012

i agree with squawkbox. while you obviously must know the equations, it's the candidate who knows the underlying principles and intuitively grasps the material that is gonna be best positioned to get an offer.

don't just stop at what is unlevered free cash flow or how do you derive it, but understand when and why you use unlevered free cash flow as oppposed to levered free cash flow.

suerte.

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Jan 24, 2012

I got 90.8MM

Jan 24, 2012

2014 ebit less taxes plus depreciation less CapEx and change in working capital.

My name is Nicky, but you can call me Dre.

Jan 24, 2012

.

Jan 24, 2012

I got 102.7mm

Jan 24, 2012

Mind posting the multiple choice answers? I came up with $102.7.

Here are my 2014 figures:
EBIT 180.4
EBIT * (1-T) 126.3
Dep. 31.6
Cap Ex 54.1
Increase in NWC 1.1

UFCF 102.7

Wasn't sure the best way how to upload the Excel spreadsheet but happy to show work if interested.

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Nov 19, 2017
GED or Bust:

Mind posting the multiple choice answers? I came up with $102.7.

Here are my 2014 figures:
EBIT 180.4
EBIT * (1-T) 126.3
Dep. 31.6
Cap Ex 54.1
Increase in NWC 1.1

UFCF 102.7

Sorry to bump such a very, very old thread and I hope I'm not contravening any forum rules by doing so.

But I was wondering if someone could please share how the depreciation is 31.6? All my other figures match but I get 32.0 for depreciation. Thank you.

Jan 24, 2012

Thanks guys. The four possible answers given are:
a. 211.0
b. 104.8
c. 98.4
d. 102.7
And I get 102.7 as well. The calc I stuffed up was adding rather than subtracting the tax shields on interest back into UFCF.

The next question is for calcualtion of the TV as at 31 December 2016.

WACC Assumptions:
pre-tax cost of debt of 6% based on the target capital structure
marginal tax rate of 35%
10 year US government bond yield on the valuation date is 2%
equity risk premium is 8%
un-levered beta of 0.80
levered beta of 0.93
80% equity and 20% debt in the target capital structure

TV is based on a perpetual growth rate of 2%

Based on these WACC assumptions I get a WACC of 8.3% (Ke = 9.4%)
For the year ending 31 Dec 2017 I have a UFCF of 114.6 which gives me a TV of 1,846.2
So for calcuation of the EV do I discount the TV from 31 Dec 2016 or 31 Dec 2017 to the valuation date of 31 Dec 2011?

Jan 24, 2012

You're shameless.

Jan 24, 2012

You're shameless.

Jan 24, 2012

I would suggest reading either of these two books so you can learn the material rather than just having people on the internet give you the answers.

http://www.amazon.com/Valuation-Measuring-Managing...
http://www.amazon.com/Investment-Banking-Valuation...

My name is Nicky, but you can call me Dre.

Jan 24, 2012

Man, your projection end in FY 2012, so you terminal value is everything after that.

Jan 24, 2012

Two things:

I got 31.6 as depreciation for 2013 instead... what are the steps to calculating depreciation from the balance sheet? I've always just straight lined it but doesn't seem to be the case here.

Also, how does one calculate NWC from the information above?

Jan 24, 2012
F. Ro Jo:

Two things:

I got 31.6 as depreciation for 2013 instead... what are the steps to calculating depreciation from the balance sheet? I've always just straight lined it but doesn't seem to be the case here.

Also, how does one calculate NWC from the information above?

Yo, read through the whole direction, Depreciation is a % of beginning net PP&E, that is how you get it.

Jan 24, 2012

A company generates revenues, and pays for expenses and capital items. What's left over is its unlevered free cash flow. That unlevered cash flow is distributed amongst holders of debt and equity (or any other holders of financial interests). As a result, unlevered FCF reflects the cash that would go to equity if the company had no debt. Similarly, unlevered beta reflects the beta of the firm if it had no debt, which is why they are comparable. Conversely, you can do a levered DCF, in which case you must calculate the beta of the equity alone and apply that to the FCF to equity after payments to debt.

Jan 24, 2012
re-ib-ny:

A company generates revenues, and pays for expenses and capital items. What's left over is its unlevered free cash flow. That unlevered cash flow is distributed amongst holders of debt and equity (or any other holders of financial interests). As a result, unlevered FCF reflects the cash that would go to equity if the company had no debt. Similarly, unlevered beta reflects the beta of the firm if it had no debt, which is why they are comparable. Conversely, you can do a levered DCF, in which case you must calculate the beta of the equity alone and apply that to the FCF to equity after payments to debt.

I thought you use a levered beta to get to unlevered free cash flows to get to enterprise value. Then take out net debt to get to equity value.

Are you saying I can use an unlevered Beta to get to levered free cash flows to get to equity value directly? How would that work?

Sorry I'm a bit confused. Basically when do you use levered or unlevered beta, and what does that get you to (FCF or levered FCF), and does that take you to enterprise or equity value?

Sorry for all the questions.

Jan 24, 2012

I think you are confusing concepts. Cash flow is calculated via simple addition and subtraction. Beta is a metric for risk that is used in the capital asset pricing model (CAPM) to determine an appropriate discount rate. Discount rates are applied to projected cash flows to get to present value.

If you have calculated unlevered free cash flow, then you would use an unlevered beta to get an unlevered discount rate. By discounting the unlevered free cash flow at the unlevered discount rate, you will determine an estimate of unlevered firm value. You can then deduct the amount of net debt held by the firm to get to estimated equity value.

Alternatively, you could start with levered free cash flow (i.e. net free cash flow to equity), and use the levered equity beta to calculate a levered discount rate. Discounting the levered free cash flow at the levered discount rate will get you directly to equity value. The prior method of calculating unlevered value is generally preferred by practitioners as you remove the effects of a potentially suboptimal capital structure and can address the underlying value of a firm's operations.

Jan 24, 2012

I think you have it backwards..

Jan 24, 2012

Nope.,, I know that Unlevered Free Cash Flow is EBITDA/EBIT and Levered Free Cash Flow =EBITDA/EBIT - interest expense.

I'm just saying that they're names are misnomers... since Unlevered Free Cash Flow sounds like all the debt has alreardy been paid for which is hasnt

Jan 24, 2012

I just generally think about them as FCFF and FCFE, instead of unlevered vs levered.

Jan 24, 2012

I don't really get your point, the names make sense to me. Unlevered free cash flow is the CF the company would have if it were unlevered.

Best Response
Jan 24, 2012

Think of it as unlevered is the cash flow to all stakeholders (equity and debt), levered cashflow takes out the debt holders by subtracting the interest paid to them and becomes the cashflow to just the equity holders

Unlevered cashflow is a good way to compare businesses by taking the differing financial structures out of the picture and showing the operational well being. This is particularly helpful because financial structure can always be changed by paying down debt or issuing additional bonds, etc. Meanwhile levered cashflow shows the company's current situation for the equity holders which is good because that tends to be what a buyer will be taking on.

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Nov 19, 2017

Just go to investopedia buddy.

Nov 19, 2017
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