What's the Difference Between Levered and Unlevered Free Cash Flow?

Unlevered free cash flow is the cash a business generates for its lenders and shareholders together, and levered free cash flow is what's left for shareholders after the lenders have been paid. The two only part ways over financing: interest paid or earned, the tax that interest saves, and any borrowing or repayment. So whenever you're unsure which version you need, ask whose cash you're counting.

I'm Stephen Turban, founder of WSG. I went to Harvard and worked at McKinsey, and I've run a lot of mock technical interviews with students headed into banking.

Unlevered free cash flow is what you discount in a DCF, so see where it fits in the 7-step walkthrough here. Levered cash flow matters more in a buyout, where paying down debt drives returns, which is why it runs through the LBO answer here.

Both Versions Make the Same Three Cash Adjustments

Both versions turn a profit figure into cash with the same three adjustments, so they differ only in where they start and in one line for borrowing. Unlevered free cash flow starts from EBIT (earnings before interest and taxes), and levered free cash flow starts from net income. The three shared adjustments are:

Add back depreciation and amortization (D&A): the cash went out in the year the asset was bought, so this year's charge lowers profit without any cash leaving.

Subtract capital expenditures (capex): the cash leaves now, while the purchase reaches profit only slowly through depreciation, so you subtract the full amount.

Subtract the increase in net working capital: when receivables and inventory rise by more than accounts payable (what the company owes its suppliers) rises, cash gets tied up in the business, so you subtract the build. A rise in payables on its own adds cash, because the company is holding on to money it owes. A decrease in net working capital frees cash, so you add it. Our net working capital guide goes through each line.

The worked numbers in this article use one made-up company, Northline, with these figures for the year:

• EBITDA: $250 million, with $50 million of D&A, so EBIT of $200 million

• Debt: $500 million at 6 percent, so $30 million of interest

• Tax rate: 25 percent

• Capex: $60 million

• Net working capital: up $10 million

For Northline, the three adjustments are plus $50 million, minus $60 million, and minus $10 million, a net $20 million reduction that's the same in both versions.

Unlevered Free Cash Flow Starts From Operating Profit

Unlevered free cash flow starts from EBIT and taxes it as if the company had no debt, so interest never enters the calculation. You'll also hear it called free cash flow to the firm (FCFF).

Formula: unlevered free cash flow = EBIT times (1 minus the tax rate), plus D&A, minus capex, minus the increase in net working capital

EBIT taxed this way is called NOPAT, net operating profit after tax. It's the profit a debt-free version of the company would earn, and that's the point: you want the cash the business generates before anyone decides how to split it between lenders and shareholders. That's why Northline's $30 million of interest never appears.

In an interview, you'd talk through Northline's numbers like this:

"EBIT is $200 million, and taxing it at 25 percent leaves $150 million of NOPAT. Adding back $50 million of D&A gets me to $200 million, subtracting $60 million of capex leaves $140 million, and subtracting the $10 million working capital build gives unlevered free cash flow of $130 million."

Northline's real taxable income is EBIT minus interest, or $170 million, so its actual tax bill is $42.5 million. The unlevered calculation charges $50 million instead, because it taxes the full $200 million. The $7.5 million difference is the interest tax shield, the tax the company saves because interest is deductible.

Unlevered free cash flow leaves out the interest tax shield because WACC, the discount rate that goes with it, already counts the shield through the after-tax cost of debt. WACC is the weighted average cost of capital, and it uses the cost of debt after tax, so the saving is already in the rate. Counting it in the cash flow as well would count the same benefit twice, which is why Wall Street Prep's tax shield guide leaves it out of unlevered free cash flow.

Levered Free Cash Flow Starts From Net Income

Levered free cash flow starts from net income, which already reflects interest and its tax saving, and then adds net borrowing. It's also called free cash flow to equity (FCFE).

Formula: levered free cash flow = net income, plus D&A, minus capex, minus the increase in net working capital, plus net borrowing

The three adjustments in the middle are the ones you've already made. Net borrowing is new debt raised minus debt repaid during the year, so it can be positive, negative, or zero, and it moves levered free cash flow even when nothing in the business has changed. Some guides subtract only the required principal repayments, but when you're valuing the equity, use net borrowing, because that's the cash shareholders can actually take out.

With no debt raised or repaid this year, Northline's two calculations look like this side by side:

Line	Unlevered	Levered
Profit before tax	EBIT of $200M	$200M minus $30M interest = $170M
Tax at 25 percent	minus $50M	minus $42.5M
After tax	NOPAT of $150M	Net income of $127.5M
Add D&A	plus $50M	plus $50M
Subtract capex	minus $60M	minus $60M
Subtract the working capital increase	minus $10M	minus $10M
Net borrowing	not included	$0
Free cash flow	$130M	$107.5M

The gap between the two is $22.5 million, which is the $30 million of interest after its $7.5 million tax shield. On a real company's statements, the gap should come out close to after-tax interest expense minus net borrowing, and if it doesn't, look for interest income or tax lines that don't follow the company's usual rate.

You'll also see free cash flow calculated as cash flow from operations minus capex. Under US accounting rules, interest paid is classified as an operating cash flow, so for a US company that shortcut is already a levered number, before any borrowing or repayment. Under international rules (IFRS), interest paid can sit in financing instead, so check where it sits before you use the shortcut.

Each Version Pairs With Its Own Discount Rate

Unlevered free cash flow is discounted at WACC to give enterprise value, and levered free cash flow is discounted at the cost of equity to give equity value. The rule underneath is that the discount rate has to belong to the same investors as the cash flow.

Unlevered free cash flow and WACC: the cash belongs to lenders and shareholders together, so the rate is a blend of what both require. WACC weights the cost of debt and the cost of equity by how much of the company each group funds at market value. The result, enterprise value, is the value of the whole business.

Levered free cash flow and the cost of equity: the cash belongs to shareholders alone, so the rate is the return shareholders require. For a company with debt, it sits above WACC, because shareholders are paid after lenders and carry more risk, while WACC blends in cheaper, tax-deductible debt. The result is equity value directly.

Mixing them up moves the answer in a predictable direction. Discounting unlevered cash flows at the cost of equity uses too high a rate, so it undervalues the business. Discounting levered cash flows at WACC uses too low a rate, so it overvalues the equity. Damodaran's valuation chapter names both errors and calls mismatching cash flows and discount rates "the key error to avoid."

How the Two Valuations Meet at Equity Value

An unlevered DCF reaches equity value by subtracting net debt, and any other claims common shareholders don't own, from enterprise value. Say Northline's unlevered free cash flow grows 2 percent a year forever and its WACC is 9 percent:

"Next year's cash flow is about $132.6 million. A stream growing at 2 percent and discounted at 9 percent is worth that figure divided by 7 percent, or about $1.89 billion of enterprise value. Subtracting net debt of $450 million, which is $500 million of debt minus, say, $50 million of cash, leaves equity value of about $1.44 billion."

Debt comes off because part of the cash flow you discounted belonged to lenders, and they're paid before shareholders. Cash goes back on because it wasn't part of the operating cash flows you discounted, which is why the bridge subtracts debt net of cash. Preferred stock and minority interest come off too when a company has them, and dividing by the diluted share count gives a value per share; our DCF walkthrough covers those steps. A full DCF also projects about five to ten years and uses this growing-perpetuity formula only for the terminal value at the end, but the bridge works the same way.

In theory, a levered DCF built on the same assumptions lands on the same equity value as an unlevered one. Damodaran says the two approaches "will yield consistent estimates of value as long as you use the same set of assumptions in valuation," and adds that getting them to agree "can be much more difficult in practice." Using the same assumptions means the company borrows each year so its mix of debt and equity stays about where WACC puts it, which Breaking Into Wall Street notes is quite complicated to get right. On Northline's numbers, a business growing 2 percent a year with a steady mix would need its $500 million of debt to grow by about $10 million a year, while the table above assumed no new borrowing. Gaps like that are why the two answers rarely come out exactly equal.

Why Most DCFs Use Unlevered Cash Flow

Bankers usually build DCFs on unlevered free cash flow because it values the business separately from how it's financed, and they keep the levered version for cases where financing is part of the business. Wall Street Prep's levered free cash flow guide says the levered DCF "is seldom used in practice, aside from for financial institutions," because their business is built around lending.

It separates the business from its financing: two companies with the same operations and different debt loads have the same unlevered free cash flow, so you can compare the businesses directly and judge the debt on its own.

It's easier to forecast: a levered DCF needs every year's interest, borrowing, and repayment before it produces a single cash flow, and repayments can swing from nothing one year to a large amount the next. An unlevered DCF leaves financing out of the cash flows and handles it once, in WACC.

It lines up with the multiples: comparable company analysis often leans on EV/EBITDA, and both halves of that multiple belong to lenders and shareholders together. An unlevered DCF also lands on enterprise value, so its result sits next to the multiples on the same page.

LBOs and Banks Are Where Levered Cash Flow Takes Over

Leveraged buyouts (LBOs) and banks are where you'd work from levered cash flow instead, because in both, financing is part of what you're analyzing.

LBOs: a private equity firm buys the company with a substantial share of the price funded by debt, and the model tracks the cash left after interest each year, because that cash decides how much debt can be paid down. Wall Street Prep's paper LBO walkthrough calculates it as net income plus D&A minus capex minus the change in working capital, which is levered free cash flow before any principal is repaid. On Northline's numbers, that's the $107.5 million above, and buyout debt would add interest and shrink it. The model then solves for the sponsor's return, measured as the internal rate of return (IRR) and the multiple on invested capital, which takes the place of a discount rate. Our LBO walkthrough goes through the full model.

Banks and other financial firms: for them, debt is part of the operating business. A bank borrows through deposits and lends that money out at a higher rate, so its interest expense is one of its main operating costs. In Damodaran's words, "most financial service firms view it as a raw material." That leaves no clean line between operating cash flow and financing, which is why banks are usually valued on equity, with a dividend discount model or price-to-book.

Three Follow-Up Questions That Test Your Understanding

"If Depreciation Goes Up by $10, What Happens to Unlevered Free Cash Flow?"

At a 25 percent tax rate, a $10 increase in depreciation raises unlevered free cash flow by $2.50, as long as the extra depreciation is deductible for tax. EBIT falls by $10, so taxes fall by $2.50 and NOPAT falls by $7.50. Adding back the full $10 of depreciation leaves unlevered free cash flow $2.50 higher. Levered free cash flow rises by the same $2.50, because interest doesn't change. Give the number first and then walk down the formula, because the interviewer is checking that you know depreciation matters to cash only through taxes.

"Can Levered Free Cash Flow Ever Be Higher Than Unlevered?"

Levered free cash flow is higher than unlevered in any year the company borrows more new debt than it pays out in after-tax interest and principal. If Northline raised $40 million and repaid nothing, its levered free cash flow would be $147.5 million against $130 million unlevered. It can also happen without any borrowing or repayment when a company earns more interest on its cash than it pays on its debt, because that net interest income reaches net income but stays out of EBIT.

"If Interest Expense Goes Up by $10, What Happens to Each Version?"

Unlevered free cash flow doesn't change, and at a 25 percent tax rate levered free cash flow falls by $7.50. Interest sits below EBIT, so NOPAT and every line after it in the unlevered calculation stay the same. Net income falls by the $10 of interest less its $2.50 tax saving, and that $7.50 drop carries straight through to levered free cash flow. In an unlevered DCF, the higher interest shows up through WACC and the bridge instead: a higher rate raises the cost of debt, while more borrowing shifts WACC's mix toward debt and, once the borrowed cash is spent, raises the net debt you subtract at the end.