Full Definition
Unlevered Free Cash Flow (UFCF), also called Free Cash Flow to the Firm (FCFF), represents the cash generated by a business's operations before any payments to debt holders. It is calculated as EBIT times (1 - tax rate), plus depreciation and amortization, minus capital expenditures, minus changes in working capital. Because UFCF ignores the capital structure, it is the appropriate input for DCF analysis when discounting at WACC—reflecting the cash available to satisfy all providers of capital (both debt and equity) proportionally according to their cost. UFCF allows companies with different leverage profiles to be compared on an operating cash generation basis. Levered Free Cash Flow (LFCF), also called Free Cash Flow to Equity (FCFE), deducts interest expense (net of tax shield), mandatory debt principal repayments, and any preferred dividends from UFCF. LFCF represents cash available exclusively to equity holders after the company has met all its debt obligations. When discounting LFCF, the appropriate discount rate is the cost of equity (not WACC), reflecting the higher risk equity holders face. LFCF is the metric PE sponsors use to model equity returns and dividend recapitalization capacity in their portfolio companies. The practical significance of this distinction is substantial in highly leveraged transactions. A company with $30M UFCF carrying $200M of debt at 7% interest has only $16M of pre-tax LFCF after $14M in interest expense ($200M x 7%)—and only $12M of after-tax LFCF. The difference between $30M unlevered and $12M levered cash flow represents the entire economic cost of the leverage. PE sponsors model this distinction carefully when evaluating dividend recaps, refinancing opportunities, and equity return timing across different leverage and interest rate scenarios.
FAQs
Which FCF measure should be used in a DCF valuation?
Use Unlevered FCF (discounted at WACC) when valuing the enterprise as a whole—comparing companies with different capital structures or performing a traditional M&A valuation. Use Levered FCF (discounted at cost of equity) when specifically valuing the equity stake in a business with a defined and stable capital structure. Both approaches should yield the same equity value if executed consistently; mismatching the FCF type with the discount rate is a common valuation error.
How do interest rate changes affect the levered vs. unlevered FCF gap?
Rising interest rates widen the gap between UFCF and LFCF by increasing the annual interest burden on floating-rate debt. A company with $200M of SOFR+350 bps debt saw its annual interest burden increase by $4M for every 200 bps rate increase during the 2022-2023 tightening cycle, directly compressing LFCF and equity returns. This dynamic triggered numerous covenant stress events in PE portfolios during that period.
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