usually i know unlevered FCF's are used for DCFs. but why do we use unlevered FCFs instead for DCF's and when are you supposed to use levered FCFs?
What is Free Cash Flow?
Free cash flow is a measure of how much money is available to investors through the operations of the business after accounting for expenses of the business such as operational expenses and capital expenditures.
Why do we add back Depreciation and Amortization to Free Cash Flow?
Depreciation and amortization are non-cash expenses - these are instead accounting expenses that recognize the cost of PP&E and intangible assets over time.
Why do we subtract the change in net working capital?
Net working capital (NWC) is calcuated as current assets - current liabilities. When examining the changes in NWC, if current assets are rising - the company is investing money in assets such as inventory. These are cash expenses that are not being captured on the income statement in operational expenses. If current liabilities are rising then the company is "gaining cash" in the sense that it has not yet paid for something that it will in the future. These might be things such as wages payable - which is being accounted for as an expense on the IS but has not yet been paid.
What is Unlevered Free Cash Flow? (Free Cash Flow to the Firm)
Typically when someone is refering to free cash flow, they are refering to unlevered free cash flow which is the cash flow available to all investors, both debt and equity. When performing a discounted cash flow with unlevered free cash flow - you will calculate the enterprise value.
Free cash flow is calculated as EBIT (or operating income) * (1 - tax rate) + Depreciation + Amortization - change in net working capital - capital expenditures.
What is Levered Free Cash Flow? (Free Cash Flow to Equity)
While unlevered free cash flow looks at the funds that are available to all investors, levered free cash flow looks for the cash flow that is available to just equity investors. It is also thought of as cash flow after a firm has met its financial obligations. When performing a discounted cash flow with levered free cash flow - you will calculate the equity value.
Levered free cash flow is calculated as Net Income (which already captures interest expense) + Depreciation + Amortization - change in net working capital - capital expneditures - mandatory debt payments.
Even if a company is profitable from a net income perspective and postive from an unlevered free cash flow perspective, the company could still have negative levered free cash flow. This could mean that this is a dangerous equity investment since equity holders get paid last in the event of bankruptcy.
How to discount levered and unlevered free cash flow?
When performing a discounted cash flow analysis on unlevered free cash flow, you are examining the cash flow available to the entire capital structure - debt holders, equity holders, and preferred equity investors - and therefore you need to use the weighted average cost of capital which looks at the costs of capital across the capital structure.
When performing a discounted cash flow analysis on levered free cash flow, you are examining the cash flow available to equity investors and should just be using the cost of equity - or the capital asset pricing model (CAPM) to discount cash flows.
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