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What the interviewer is testing
Whether you can write both formulas, explain what capital providers each one belongs to, and match each to the correct discount rate and valuation output.
Answer framework
- Unlevered FCF: cash flow available to all capital providers, before interest.
- Formula: EBIT x (1 - tax rate) + D&A - capex - increase in net working capital.
- Levered FCF: cash flow available to equity holders after interest and required debt repayments.
- Formula: net income + D&A - capex - increase in NWC - mandatory debt repayments (plus net new borrowing if modeled).
- Matching: unlevered FCF discounted at WACC gives enterprise value; levered FCF at cost of equity gives equity value.
Sample answer
Unlevered free cash flow is the cash the business generates before any payments to lenders, so it belongs to all capital providers. I calculate it as EBIT times one minus the tax rate, plus D&A, minus capex, minus the increase in net working capital. Starting from EBIT means interest expense, and the tax shield it creates, are excluded, so the result does not depend on how the company is financed.
Levered free cash flow is what is left for equity holders after the company services its debt. It starts from net income, which is already after interest, then adds D&A, subtracts capex and the increase in working capital, and subtracts mandatory debt repayments. If the company is borrowing new debt, net borrowing is added.
The key is matching. Unlevered free cash flow goes with WACC, because it belongs to debt and equity holders together, and the DCF gives enterprise value. Levered free cash flow goes with cost of equity and gives equity value directly. Bankers usually use unlevered DCFs because capital structure can change and the result is easier to compare across companies; levered cash flow matters more in LBOs and for banks.
Likely follow-ups
Common mistakes
- Discounting levered FCF at WACC.
- Subtracting interest when calculating unlevered FCF.
- Getting the sign of the working capital change wrong.
- Forgetting mandatory debt repayments in levered FCF.
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Related questions
Based on questions #49, #14, #15 in the full question bank.