Unlevered free cash flow
The cash a business produces for everyone who funds it, before any of them is paid.
- Build unlevered free cash flow from EBITDA, line by line
- Explain why interest is left out, and where its tax saving goes instead
- Work backwards from a model's free cash flow to the capex it assumes
- Tell unlevered from levered free cash flow, and pair each with its discount rate
The intuition
Imagine you own a food truck. At the end of the year you want to know one thing: how much cash could I take out of this business without it shrinking? Not profit. Cash.
You start with what the truck earned from selling food, less the costs of running it. You pay tax on those earnings. The truck lost value over the year, and your accountant charged that as depreciation, but no cash left your pocket for it, so it goes back in. Then you take off the cash you really did spend: a new grill (capex) and the extra stock sitting in the fridge (working capital).
Unlevered means as if the business had no debt. Whether you bought the truck with a loan or with savings does not change how much cash the truck produces. How it was paid for is a separate question, and it is answered in the discount rate.
Why it works
A DCF values the whole business — its enterprise value — which belongs to lenders and shareholders together. So the cash flow you discount has to be the cash available to all of them, measured before any of them is paid. That is unlevered free cash flow.
Every line has a reason:
- Tax on EBIT, not on pre-tax income. Pre-tax income has interest already taken off, which would sneak the financing decision into the cash flow. So you tax operating profit as if there were no interest.
- Add back D&A. Depreciation and amortization reduce profit but are not cash payments. The cash for those assets went out as capex, in the year they were bought.
- Subtract capex. Machines, buildings and software cost cash when they are bought, whether or not the cost shows up on the income statement that year.
- Subtract the increase in working capital. Growing receivables and inventory ties up cash; a growing payables balance frees it. If working capital falls, the change adds cash instead.
- Leave interest out. It is the lenders' reward. It lives in the discount rate — WACC uses the after-tax cost of debt — so putting it in the cash flow as well would count it twice.
| EBITDA | 100 |
| − D&A | 20 |
| = EBIT | 80 |
| − Tax at 25% on EBIT | 20 |
| = NOPAT | 60 |
| + D&A added back | 20 |
| − Capex | 30 |
| − Increase in working capital | 5 |
| = Unlevered free cash flow | 45 |
Interest, whatever it is, appears nowhere.
The formulas
Operating profit: earnings after the wear and tear on assets, before interest and tax.
Net operating profit after tax: the tax the business would pay if it had no debt.
Add back the non-cash charge; take off the cash reinvested in assets and in working capital.
The same number, starting from EBITDA. Here D&A only matters for the tax it saves: D&A × t.
What is left for shareholders once lenders are paid (before any debt repayment). It pairs with the cost of equity, not WACC.
Worked example
A question straight from the practice pool, with fresh numbers. Try it on paper first, then reveal the working one step at a time.
See it move
Same company, same numbers. Move a slider and the recipe recalculates every bar.
- Push working capital up. Unlevered free cash flow falls by exactly the same amount: buying stock is not an expense, so there is no tax saving to soften it.
- Raise D&A while EBITDA stays put. Free cash flow rises, but only by D&A × tax rate. Depreciation is not cash; its tax deduction is.
- Raise capex. Every dollar comes straight off free cash flow, even though nothing above EBIT moved.
- Notice what never moves the bridge: interest. Whatever the company pays its lenders, unlevered free cash flow is the same.
Run it backwards
Interviewers love to hand you the answer and ask for an input. Same company, run in reverse: the model's free cash flow is known, and capex is the unknown.
Nothing new is needed: it is the same bridge read from the other end. Build every line you can, and the gap between that and the stated free cash flow has to be capex.
This is how you sanity-check someone else's model. Back out the capex it assumes and compare it with D&A. Capex well above D&A says the company is growing its asset base; capex below D&A, year after year, says the assets are wearing out faster than they are replaced.
Traps
Say it in the interview
“Walk me through how you get to unlevered free cash flow.”
Check yourself
4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.
Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.
- UFCF = EBIT × (1 − t) + D&A − capex − Δ NWC.
- Tax EBIT, never profit after interest.
- Interest lives in WACC, not in the cash flow.
- Working capital up means cash down, one for one.