Levered vs. Unlevered Free Cash Flow
Unlevered free cash flow belongs to everyone with a claim on the business. Levered free cash flow belongs to equity holders alone, after debt has already been served. Here is how each is built, and which valuation approach each one feeds.
What is the difference between levered and unlevered free cash flow?
Unlevered free cash flow belongs to debt and equity holders together; levered free cash flow belongs to equity holders alone. Unlevered FCF is calculated before interest and debt repayment and is discounted at WACC to give enterprise value. Levered FCF is calculated after both and is discounted at the cost of equity to give equity value directly.
Key takeaways
- Unlevered FCF = EBIT × (1 − tax rate) + D&A − capex − ΔNWC.
- Levered FCF = unlevered FCF − after-tax interest − mandatory debt repayment.
- The discount rate must match the cash flow: WACC for unlevered, cost of equity for levered.
- Unlevered FCF discounted at WACC produces enterprise value; levered FCF at the cost of equity produces equity value.
- With no debt, levered and unlevered free cash flow are identical.
- A standard DCF uses unlevered free cash flow; levered approaches show up in LBO work and in valuing financial institutions.
What is levered vs. unlevered free cash flow?
Unlevered free cash flow (UFCF) is the cash a business generates that belongs to everyone with a claim on it, debt and equity holders together, before any financing decisions are made. It's the version covered in full on the DCF guide, and the one used in a standard DCF.
Levered free cash flow (LFCF) is what's left over for equity holders specifically, after the business has already paid its debt holders: interest expense and any mandatory debt repayment for the period.
How do you calculate each one?
Levered FCF = Net Income + D&A − Capex − ΔNWC − Mandatory Debt Repayment
or, bridging directly from UFCF:
Levered FCF = Unlevered FCF − Interest Expense × (1 − tax rate) − Mandatory Debt Repayment
Both LFCF formulas have to agree, since net income is simply EBIT minus interest minus taxes: starting from net income already has after-tax interest baked in, while starting from UFCF requires subtracting it out explicitly.
Worked example, continuing the DCF guide's own numbers: EBIT of $100, a 25% tax rate, $20 of D&A, $30 of capex, and $10 of ΔNWC gives UFCF of $55. Add $16 of interest expense and $10 of mandatory debt repayment.
Levered FCF = $55 − $12 − $10 = $33
Which discount rate do you use for each, and what does each produce?
UFCF belongs to both debt and equity holders, so it's discounted at WACC, a blended rate reflecting both, and produces enterprise value directly. LFCF belongs to equity holders only, so it's discounted at the cost of equity alone, and produces equity value directly, skipping the enterprise-value bridge (see the enterprise value guide) entirely.
UFCF at WACC is the standard approach for a typical operating company DCF. LFCF at the cost of equity shows up more often in contexts where the capital structure and its mandatory paydowns are already explicitly modeled, financial-sponsor and LBO analyses in particular, and in valuing banks and other financial institutions, where an enterprise-value framework fits awkwardly since debt functions more like a raw material of the business than a source of financing layered on top of it.
| Unlevered FCF | Levered FCF | |
|---|---|---|
| Whose cash it is | Debt and equity holders together | Equity holders only |
| Starting point | EBIT, taxed directly (NOPAT) | Net income, or unlevered FCF less financing |
| Deducts interest expense? | No | Yes, on an after-tax basis |
| Deducts mandatory debt repayment? | No | Yes |
| Discount rate | WACC | Cost of equity |
| Valuation output | Enterprise value | Equity value directly |
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Common free cash flow interview questions
Why does levered free cash flow subtract mandatory debt repayment, which isn't an income statement expense?
Mandatory debt repayment (principal, not interest) is a real cash outflow required by the loan agreement, even though it never appears as an expense on the income statement. Since levered free cash flow is meant to show what's actually left over for equity holders in cash, it has to account for that repayment even though net income doesn't.
Which one should you use to value a bank?
Financial institutions are typically valued using an equity-side approach, closer to levered free cash flow discounted at the cost of equity (or a dividend discount model), rather than an unlevered-FCF-at-WACC enterprise value approach, since debt is a core input to a bank's business rather than a financing choice layered on top of it.
Why does unlevered free cash flow ignore interest expense entirely?
Unlevered free cash flow is meant to represent the cash the operating business generates independent of how it's financed, so it deliberately excludes interest, a financing item, and instead gets discounted at WACC, a rate that already reflects both debt and equity holders' required returns.
If a company has no debt, are levered and unlevered free cash flow the same?
Yes. With no debt, there's no interest expense and no mandatory debt repayment to subtract, so levered free cash flow equals unlevered free cash flow.
Which one is used in a standard DCF?
Unlevered free cash flow, discounted at WACC, to arrive at enterprise value, which then bridges to equity value. This is the version covered in full on the DCF guide.