Free Cash Flow (FCF)
Cash generated by a business after operating expenses and capital expenditures, available to be distributed to (or reinvested by) capital providers. The core input to a DCF valuation.
Free Cash Flow (FCF) · the mechanism
30 sec read
Build unlevered and levered free cash flow, and know which discount rate each one pairs with.
Where it comes up. A VP asks why your DCF produced an equity value directly. Somewhere in the build a levered cash flow met a WACC, and the model has been wrong ever since.
Unlevered: what the whole business generates
EBIT, less tax on EBIT, plus depreciation and amortisation, less capex, less the increase in net working capital. No interest anywhere, because this cash belongs to debt and equity holders together.
Levered: what is left for shareholders
Start from net income, which is already after interest and tax, add back non-cash items, subtract capex and the working capital increase, and subtract mandatory debt repayment. What remains is the shareholders’.
Pair each with the right rate
Unlevered discounts at WACC and produces enterprise value. Levered discounts at the cost of equity and produces equity value directly. There is no third combination, and mixing them is the error that ends a valuation question.
Worked through
EBIT $400m, tax 25%, D&A $120m, capex $150m, working capital up $30m, interest $60m, mandatory repayment $50m.
- Unlevered FCF
- $400m × 0.75 + $120m − $150m − $30m = $240m
- Net income
- ($400m − $60m) × 0.75 = $255m
- Levered FCF
- $255m + $120m − $150m − $30m − $50m = $145m
The $95m gap is interest after tax ($45m) plus the mandatory repayment ($50m). Discount the $240m at WACC for enterprise value; discount the $145m at cost of equity for equity value. Both routes should land in the same place.
Check yourselfWhy is the tax on unlevered free cash flow calculated on EBIT rather than on pre-tax income?
Answer once you have one →
Because unlevered cash flow deliberately ignores the capital structure, and the actual tax bill is lower thanks to the interest deduction. Taxing EBIT gives you the tax the business would pay with no debt. The value of the interest deduction is not thrown away; it is captured in the WACC, through the after-tax cost of debt. Counting it in both places double-counts the shield.
Be able to say this back next week
- Built unlevered free cash flow from EBIT without touching interest
- Said unlevered goes with WACC and levered with cost of equity
- Taxed EBIT rather than pre-tax income, and said why that avoids double-counting the shield
Why Free Cash Flow (FCF) matters in interviews
Free cash flow is what actually pays down debt and funds distributions, so it is the number that matters in both a DCF and an LBO. Interviewers ask about it to see whether you can distinguish accounting profit from cash, and whether you know which version of FCF pairs with which discount rate.
How it works in practice
Unlevered free cash flow (free cash flow to the firm): EBIT − taxes on EBIT + D&A − capital expenditure − increase in net working capital. It is the cash available to all capital providers, and it is discounted at WACC.
Levered free cash flow (free cash flow to equity): starts from net income, adds back D&A, subtracts capex and the increase in working capital, then adjusts for mandatory debt repayment. It is the cash available to shareholders, and it is discounted at the cost of equity.
A worked case: EBIT of $400m, a 25% tax rate, D&A of $120m, capex of $150m and a $30m increase in working capital. Unlevered FCF = $400m − $100m + $120m − $150m − $30m = $240m.
What candidates get wrong
- Subtracting interest in an unlevered calculation. Unlevered means before financing; the cost of debt lives in WACC instead.
- Getting the working capital sign wrong. An increase in net working capital consumes cash and is subtracted.
- Taxing EBT rather than EBIT in the unlevered build. Unlevered FCF taxes EBIT so the calculation stays independent of the capital structure.
Free Cash Flow (FCF): frequently asked questions
What is the difference between unlevered and levered free cash flow?
Unlevered free cash flow is calculated before interest and is available to all capital providers, so it is discounted at WACC and produces enterprise value. Levered free cash flow is after interest and mandatory debt repayment, is available only to equity holders, and is discounted at the cost of equity to produce equity value directly.
Why is depreciation added back to free cash flow?
Because it is a non-cash accounting charge. Depreciation reduces reported earnings but no money leaves the business in that period — the cash went out when the asset was bought, which is captured separately as capital expenditure.
Where Free Cash Flow (FCF) comes up
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DCF interview questions guideRelated Valuation terms
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