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Unlevered free cash flow belongs to all capital providers and pairs with the weighted average cost of capital (WACC) to calculate the enterprise value. Levered free cash flow belongs only to equity holders and pairs with the cost of equity. Both formulas differ by three adjustments, which include after-tax interest expense, net new borrowing, and the tax calculation method. Unlevered metrics remain capital-structure-neutral, which explains why the metric dominates mergers and acquisitions, cross-company comparisons, and the institutional equity research that most analysts use for discounted cash flow work. Levered figures are more complex to calculate and more volatile in practical use, partly because errors in operating assumptions become amplified through fixed debt service costs.
What unlevered free cash flow measures
Unlevered free cash flow asks a deliberately hypothetical question: what level of cash would this business generate if it carried no debt at all? It represents the cash available to all capital providers before any financing costs are deducted. Because it strips out the effect of a firm's capital structure, it provides a pure view of underlying operating performance.
This capital-structure neutrality is why investment banks, private equity firms, and equity research teams default to the unlevered figure when building discounted cash flow models. Two companies in the same industry with different leverage can be compared directly on their unlevered cash generation, because debt decisions have been removed from the picture.
Is unlevered free cash flow the same as free cash flow?
Not quite. The generic term "free cash flow" typically means operating cash flow less capital expenditures. This everyday FCF figure retains the effect of interest payments, because interest is already deducted before operating cash flow is calculated under most accounting standards.
Unlevered free cash flow goes further: it adds back the after-tax cost of interest, removing the impact of debt financing entirely. The result is a measure that belongs to everyone in the capital structure, not just equity holders. A 2019 study by Pinto, Robinson, and Stowe, cited in the CFA Institute curriculum, found that approximately 79% of equity analysts use a discounted value approach in their work. Among those analysts, 86.9% use a discounted free cash flow model specifically.
What levered free cash flow measures
Levered free cash flow is the cash remaining for common equity shareholders after all financial obligations have been met. The metric includes interest payments on debt, mandatory debt repayments, and any new borrowing raised during the period. Put plainly, it is the cash a business could return to its shareholders as dividends, buybacks, or retained earnings.
Where unlevered FCF ignores the capital structure, levered FCF is defined by it. Two companies with identical operating performance but different debt loads will show very different levered free cash flows. The more debt a company carries, the larger its interest bill, and the smaller the residual cash available to equity.
Does free cash flow include financing costs?
Unlevered FCF does not. That is its defining characteristic. Levered FCF does. The formula for levered FCF explicitly subtracts after-tax interest expense and adds net new borrowing. New debt raised is cash that equity holders can use. Debt repaid is cash that leaves the equity holder's residual pot.
How do you calculate unlevered and levered free cash flow?
The unlevered formula, starting from EBIT — Free Cash Flow to Firm (FCFF) or unlevered free cash flow:
FCFF = EBIT x (1 − Tax Rate) + Depreciation − Capital Expenditure − Change in Working Capital
No interest expense appears anywhere. The tax calculation treats the business as if it had no debt at all, not the actual tax bill reduced by interest deductions.
The levered formula, starting from net income — Free Cash Flow to Equity (FCFE) or levered free cash flow:
FCFE = Net Income + Non-Cash Charges − Fixed Capital Investment − Working Capital Investment + Net Borrowing
Or, derived directly from unlevered FCF:
FCFE = FCFF − Interest × (1 − Tax Rate) + Net Borrowing
This second expression makes the mechanics transparent: start with the firm-level cash flow, pay the lenders their after-tax interest, account for any debt raised or repaid, and what remains belongs to equity.
What is the difference between EBITDA and unlevered free cash flow?
EBITDA is frequently used as a rough proxy for operating cash generation, but it is not the same as unlevered FCF. Unlevered FCF differs because it accounts for three items that EBITDA ignores: taxes on operating profit, capital expenditure, and working capital movements.
CFA Institute research identifies that using EBITDA as a starting point for FCFF calculation can yield materially different results from the same dataset unless adjustments are made for non-operating items and differential tax treatment. Modern treasury platforms powered by AI-driven categorisation and forecasting are designed to account for all three adjustments. The architecture ensures the human stays in control and the process remains fully auditable, arriving at a reliable unlevered figure without exposing the firm to unchecked automation risks.
The same company, both figures
Consider a UK manufacturer with the following financials in £ millions: EBIT of 80, a 25% tax rate (the current UK main corporation tax rate for profits over £250,000), depreciation of 15, capital expenditure of 20, an increase in net working capital of 5, an interest expense of 10, and net new borrowing of 4.
Unlevered FCF: £80 × 0.75 + £15 − £20 − £5 = £50m
This £50m belongs to all capital providers.
Levered FCF: £50 − £10 × 0.75 + £4 = £46.5m
This £46.5m is what equity shareholders retain after lenders are serviced. The gap of £3.5m reflects the net cost of debt. If the company were entirely equity-funded, both figures would converge.
Which figure goes with which discount rate
Mismatching cash flows and discount rates is one of the most common errors in valuation practice. The pairing must be precise:
| Cash flow metric | Discount rate | Output |
|---|---|---|
| Unlevered FCF | WACC | Enterprise value |
| Levered FCF | Cost of equity | Equity value |
The weighted average cost of capital WACC is a blended rate reflecting the required return of both debt holders and equity investors, weighted by their proportions in the capital structure. Because unlevered FCF belongs to both groups, WACC is its natural discount rate. Cost of equity reflects only what equity investors demand, so it pairs with levered FCF.
Why does a DCF use unlevered free cash flow?
The unlevered DCF dominates in investment banking, private equity, and institutional cash flow forecasting for three reasons. First, it separates operating value from financing decisions. Second, it enables direct comparison across companies with different leverage. Third, it produces enterprise value as a clean output from which net debt is subtracted to arrive at equity value.
In M&A contexts, buyers often intend to change the target's capital structure entirely. The unlevered FCF captures operating value independent of existing debt, making it the natural choice for acquisition modelling.
When to use each one
| Use unlevered FCF when… | Use levered FCF when… |
|---|---|
| Building a standard DCF for enterprise valuation | Valuing equity directly in stable leverage scenarios |
| Comparing companies across different capital structures | Analysing financial institutions where debt is operational |
| Valuing acquisition targets | Measuring residual cash for dividends or buybacks |
| Running LBO or restructuring scenarios | Working with price-to-FCF equity multiples |
| A company has complex or changing leverage | Equity is the only instrument being valued |
Professional services firms typically select the unlevered approach for DCF valuations of operating businesses, because free cash flows can be reliably estimated and WACC provides an appropriate discount rate. Treasury teams managing intercompany funding often need both figures: unlevered FCF for group-level planning, levered FCF for subsidiary dividend capacity analysis.
Why the levered figure is the harder one to get right
Levered FCF is harder to calculate and more volatile in real use than its unlevered counterpart. Four factors compound the difficulty:
Debt schedule dependency
Any error in modelling interest payments or principal repayments flows directly into the levered figure.
Circularity in cost of equity
The discount rate depends on leverage, which itself changes as debt is repaid or issued.
Tax shield volatility
The benefit of debt shifts with tax rates or loss-making periods.
Net borrowing ambiguity
Forecasting future debt issuance is inherently uncertain.
Because levered FCF sits below unlevered FCF in the cash flow waterfall, forecast errors in operating cash flows are leveraged by the fixed nature of debt service. A small miss on EBITDA can translate into a massive miss on the levered output for a highly leveraged business.
How good is the forecast behind either figure?
Both unlevered and levered FCF are only as reliable as the assumptions underpinning them. Capital expenditure forecasts, working capital movements, tax rate projections, and revenue growth all feed directly into both figures. Errors here are amplified in multi-year models, particularly in the terminal value, which generally accounts for a vast majority of total enterprise value in most standard valuation exercises.
Free cash flow as commonly reported is a non-GAAP measure with no uniform definition. Companies may define it differently: some exclude maintenance capex but include growth capex, others exclude lease payments, others do not. Analysts reconciling treasury data should standardise these reported figures back to a clean baseline before they can be compared across peers or used in serious valuation work.
Treasury platforms that integrate real-time bank feeds, ERP data, and AI-assisted transaction categorisation are designed to support finance teams in building rolling cash flow forecasts at the entity and facility level. This infrastructure drastically improves the reliability of both unlevered and levered projections, whilst always ensuring the human stays in control as the final decision-maker.
