Unlevered Free Cash Flow

Used in financial modeling to value a firm

What is unlevered free cash flow?

Unlevered Free Cash Flow (also known as Free Cash Flow to the Firm or FCFF for short) is a theoretical cash flow figure for a business, assuming the company is completely debt free and thus has no interest expense.  Unlevered Free Cash Flow is used in financial modeling to determine the enterprise value of a firm.

 

Unlevered free cash flow formula?

The formula is:

Unlevered free cash flow = EBIT – Taxes + Depreciation & Amortization – Capital Expenditures – increases in non-cash working capital

unlevered free cash flow formula

 

Why is unlevered free cash flow used?

Unlevered free cash flow is used to remove the impact of capital structure on a firm’s value and make companies more comparable.  Its principal application is in valuation, where a discounted cash flow (DCF) model is built to determine the net present value (NPV) of a business.  By using unlevered cash flow the enterprise value is determined, which can easily be compared to the enterprise value of another business.

 

Why is capital structure ignored?

There are two main reasons capital structure is ignored when performing a valuation:

  1. It makes firms comparable
  2. Capital structure is somewhat discretionary, and owners/managers could theoretically place a different capital structure of their choosing on the firm

Let’s explore each of these ideas in more detail below.

Comparability. Since some companies have a high interest expense, while others have little to no interest expense, the levered cash flow of two firms can be skewed by the impact of interest.  By removing the interest expense and recalculating taxes it’s much easier to make an apples to apples comparison.

Discretionary. This point is somewhat theoretical, as firms may be limited in how much flexibility they have, but in theory, the owners or managers of the business can put whatever capital structure they want on the business.

 

How to calculate free cash flow to the firm

Here is a step-by-step example of how to calculate unlevered free cash flow (free cash flow to the firm):

  1. Begin by EBIT (Earnings Before Interest and Tax)
  2. Calculate the theoretical taxes the company would have to pay if they didn’t have a tax shield (i.e. without deducting interest expense)
  3. Subtract the new tax figure from EBIT
  4. Add back depreciation and amortization expenses
  5. Subtract any increases in non-cash net working capital
  6. Subtract any capital expenditures

 

Unlevered Free Cash Flow example

 

The is most common cash flow metric used for any type of financial modeling valuation.

As you can see in the example above and section highlighted in gold, EBIT of $6,800 less taxes of $1,360 (without deducting interest), plus depreciation and amortization of $400, less an increase in non-cash working capital of $14,000, less capital expenditures of $40,400 results in unlevered free cash flow of -$48,560.

 

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Arriving at equity value

When using unlevered free cash flow to determine the Enterprise Value (EV) of the business a few simple steps can be taken to arrive at the equity value of the firm.

To arrive at equity value, take the following steps:

  1. Add the cash balance
  2. Subtract any debt
  3. Subtract any minority interest

To learn more, see our guide on equity value vs enterprise value.

 

Video explanation

Below is a video explanation of how unlevered free cash flow (free cash flow to the firm) works.

 

Additional resources

This has been a guide to unlevered free cash flow and free cash flow to the firm (FCFF).  The best way to completely understand this metric is through practicing financial modeling and building the calculation yourself in Excel from scratch.

CFI is the official global provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification, designed to transform anyone into a world-class financial analyst.

Additionally, these free resources may be a big help to you:

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