14.2 Unlevered Free Cash Flow

Unlevered Free Cash Flow as the DCF Numerator

A DCF is only as good as the cash flows you discount. CFI's going-concern DCF discounts unlevered free cash flow (UFCF) — also called free cash flow to the firm (FCFF) — at WACC, and the present value is enterprise value. UFCF is the cash the operating business generates for all capital providers after operating expenses, tax computed as if the firm had no interest, capital expenditure, and net working capital investment.

That definition has a negative as well as a positive. UFCF is not cash after interest. It is not cash after debt principal repayments, optional revolver draws, share buybacks, or dividends. Those are financing flows. They belong in the debt schedule and in the EV-to-equity bridge, not in the DCF numerator.

If you have already built a three-statement model, UFCF is a derived schedule, not a fourth statement. You pull EBIT from the income statement, tax at the unlevered rate, add non-cash charges, and subtract the reinvestment you already modeled as capex and the change in operating working capital.

CFI's Build, Step by Step

CFI's working sequence is:

1. Start with earnings before interest and taxes (EBIT).
2. Subtract tax as if there were no interest tax shield — that is, EBIT × tax rate, not the actual tax line that already deducted interest.
3. Add depreciation and amortization (D&A) (and other operating non-cash charges, if they reduced EBIT).
4. Subtract the increase in net working capital (ΔNWC). A decrease in NWC is a source of cash and is added.
5. Subtract capital expenditure (capex).

In compact form:

UFCF = EBIT − tax as if unlevered + D&A − ΔNWC − capex

which is the same as

UFCF = NOPAT + D&A − capex − ΔNWC

where NOPAT (net operating profit after tax) = EBIT × (1 − t).

Do not start from net income and hope. Net income has already deducted interest (and often preferred dividends and non-operating items). You would be building levered cash flow by accident, then discounting it at WACC — a mismatch that understates value if the firm has debt, because you would penalize the cash flows for interest and discount at a rate that already includes the cost of debt.

CFI's Numeric Illustration

CFI uses a concrete illustration you should be able to reproduce without looking it up:

Check the tax rate: 1,360 / 6,800 = 20%. NOPAT = 6,800 − 1,360 = 5,440. Then 5,440 + 400 − 14,000 − 40,400 = −48,560.

The cash flow is negative. That is not a modeling error by itself. The firm is reinvesting: NWC absorbs 14,000 and capex absorbs 40,400, far more than NOPAT plus D&A. Growth years often show negative UFCF. Value in a DCF then has to come from later forecast years and from terminal value. If every year including the terminal year is this cash-flow hungry, the DCF should not produce a large positive EV — and that, too, is information.

Common arithmetic traps on this exact illustration:

• Stopping at NOPAT + D&A = 5,840 (you have not yet paid for reinvestment).
• Forgetting the NWC outflow, which lands on −34,560.
• Flipping the sign to +48,560 because "cash flow should be positive."

Why Tax as if Unlevered

Actual tax on the income statement is (EBIT − interest + interest income) × t, plus deferred items. If you used that tax number inside UFCF, the cash flow would already contain the interest tax shield. WACC also contains the shield, through Rd × (1 − T). Counting the shield in both places overstates value.

CFI's fix is clean: compute tax on EBIT, as if the firm had no interest. The shield then lives in one place — WACC. That is the same discipline as pairing the cash flow with the right discount rate, which the DCF chapter will press harder.

Why UFCF Ignores Capital Structure

CFI gives two practical reasons to keep leverage out of the cash-flow forecast:

1. Comparability. Two firms with the same operations but different debt loads will have different interest expense, different tax, and different free cash flow to equity (FCFE). Their UFCF should still look alike. That is why UFCF is the quantity you can compare across peers and why it pairs with EV multiples rather than P/E.
2. Discretion. Management can issue debt, repay debt, pay dividends, or buy back stock. Those choices should not masquerade as operating performance. Isolating operations in UFCF keeps the forecast honest; you still honor leverage in WACC (the required return on the mix) and in the bridge (subtract the debt you actually owe).

Ignoring capital structure inside UFCF is not the same as pretending debt does not exist. Debt exists. It just is not a line in the UFCF formula.

Reinvestment Lines, a Second Worked Year, and the Equity Bridge

The bar chart shows absolute magnitudes from CFI's illustration so you can see that reinvestment (NWC 14,000 and capex 40,400) swamps NOPAT plus D&A. The UFCF bar is the absolute value of −48,560; the signed result remains negative.

Net Working Capital

ΔNWC is the change in operating current assets minus operating current liabilities. Typical operating current assets: receivables, inventory, prepaid expenses. Typical operating current liabilities: accounts payable, accrued expenses, deferred revenue. Do not put surplus cash or short-term interest-bearing debt into this NWC stack. Cash is handled in the EV bridge; short-term interest-bearing debt is part of net debt.

• An increase in receivables or inventory uses cash → subtract from UFCF.
• An increase in payables provides cash → reduces NWC → adds to UFCF.
• Sign errors on ΔNWC reverse growth-year cash needs and are among the easiest DCF mistakes to miss because the three-statement model can still balance.

Capex and D&A

Capex is cash spent on long-term operating assets (PP&E, and often capitalized software). D&A is the non-cash allocation of past capex (and intangibles) that reduced EBIT. You add D&A back because it was not cash this period; you subtract this period's capex because it was cash. In a steady state, capex roughly equals D&A plus inflation plus growth capex. In a build-out year, capex can dwarf D&A — that is exactly CFI's illustration.

Never subtract D&A and capex without the add-back. Never treat EBITDA as "close enough" to UFCF. EBITDA has not paid tax, has not paid capex, and has not funded NWC.

UFCF versus FCFE versus EBITDA

Core FMVA DCF uses the middle row. An FCFE DCF is valid in theory but is not the CFI core template, and it requires a carefully consistent debt schedule inside the cash flows. Do not mix: UFCF discounted at Re, or FCFE discounted at WACC.

Second Worked Example: Cedar Components, Year 1

Cedar Components, a different firm from CFI's illustration, shows:

• EBIT = $12,500 thousand
• Tax rate = 25%
• D&A = $1,800 thousand
• Opening operating NWC = $6,200 thousand; closing = $6,900 thousand
• Capex = $2,400 thousand

NOPAT = 12,500 × (1 − 0.25) = $9,375 thousand. ΔNWC = 6,900 − 6,200 = $700 thousand (a use of cash). UFCF = 9,375 + 1,800 − 700 − 2,400 = $8,075 thousand.

If Year 2 instead collected receivables aggressively and NWC fell to $6,000 thousand, ΔNWC would be −$900 thousand (a source of cash), and that year would add 900 rather than subtract 700, all else equal. The sign on ΔNWC follows the change, not the level.

Suppose someone "helps" Cedar's UFCF by deducting Year 1 interest of $900 thousand and then applying the 25% tax to EBT of 11,600. That hybrid is neither UFCF nor a clean FCFE (FCFE would also need net borrowing). Discounting it at WACC would double-count part of the debt claim. Leave interest out of UFCF.

Arriving at Equity Value

Once you have a forecast of UFCF, the DCF (next chapter) discounts it at WACC, including terminal value, to EV. CFI's arriving at equity value step is then the reverse of the identity in section 14.1:

• Add cash (and non-core investments)
• Subtract debt (market value of interest-bearing debt)
• Subtract preferred
• Subtract NCI
• Divide by fully diluted shares

Worked with Northline's claims from section 14.1 and a hypothetical DCF EV of $1,900 million:

Equity value = 1,900 + 70 − 390 − 80 − 45 = $1,455 million. Diluted shares = 51.5 million. Implied value = 1,455 / 51.5 ≈ $28.25 per share.

Add cash because equity owns the non-operating cash you stripped out of EV. Subtract debt, preferred, and NCI because those claims have priority (or a parallel claim, in NCI's case) on the enterprise you just valued. If you skip NCI, you give the parent's common shareholders a piece of the subsidiary that belongs to outside owners.

The next chapter takes this UFCF schedule, applies WACC (and the mid-year convention), and adds terminal value. Do not jump from one year of UFCF to a price target. A single year — especially CFI's −48,560 illustration — is an input, not a valuation.

Exam Traps for Section 14.2

• Starting from net income and calling the result UFCF.
• Using actual tax after interest, then also using after-tax cost of debt in WACC.
• Treating an NWC increase as a source of cash.
• Subtracting D&A instead of adding it, or skipping capex.
• Discounting UFCF at the cost of equity.
• Including debt issuance proceeds or dividends in UFCF.
• Stopping at EV and calling it a per-share value without the bridge and diluted shares.
• Building a full LBO cash-flow waterfall; that elective is not on the final.