Hence, using unlevered cash flow gives a much better estimate of the value a business generates by avoiding the effects of its capital structure. If a good value-generating business has too much debt, it can be reduced and vice versa. While valuing businesses, investors generally like not to include the effect of varying capital structure as it distorts the actual value it generates. The remainder then belongs to the shareholders. In contrast, in a levered business, cash flows generated by the business are used to pay debt holders their share of interest and principal first. In an unlevered business, all the cash flows generated by the business belong to the equity shareholders. An "unlevered" firm then uses no debt capital and only equity. When a business uses debt, it is considered "levered," and the amount of debt used relative to equity is called "leverage." The more the debt used, the higher its leverage. what is unlevered free cash flow?īefore taking a deep dive into this topic, it is essential to illustrate what the term "unlevered" means and where it is used, to improve understanding of this concept. Hence, using unlevered cash flows helps predict how reliable cash flow can be expected to pay the debtholders. It is always better to use more debt to finance a business, provided there is sufficient cash flow to meet the periodic repayments. In these industries, investors like to first look at the value of the entire business and then decide on the capital structure. The most prominent industries where this metric is used along with DCF are private equity and corporate finance as part of capital structure decisions which are very important to generate optimum returns to the equity shareholders. Hence, to have a comparable metric across the entire valuation process, using unlevered Free Cash Flow is preferred along with the weighted average cost of capital (WACC) to derive a company's value. This metric is most useful when used as part of the discounted cash flow (DCF) valuation method, where its benefits shine the most.Īnother reason for its prominence is that most multiple-based valuation techniques, like comparable analysis, use enterprise value (EV) which includes both the debt and equity value of a company. Unlevered free cash flow (UFCF) is the cash generated by a company before accounting for financing costs.
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