Unlevered free cash flow (UFCF) is the foundation of any discounted cash flow (DCF) analysis, one of the most important valuation methodologies in investment banking. If you cannot calculate UFCF correctly, your entire DCF will be wrong. That makes this topic a near-certainty in technical interviews at banks and private equity firms alike.
In this guide, we will cover the UFCF formula from the ground up, walk through each adjustment, explain the difference between unlevered and levered free cash flow, and address the most common interview questions on this topic.
What Is Unlevered Free Cash Flow?
Unlevered free cash flow represents the cash flow generated by a company’s core operations that is available to all capital providers: both debt holders and equity holders, before any debt service (interest payments, principal repayments) is made. It is called “unlevered” because it removes the effect of the company’s capital structure (its leverage, or debt level).
This is a critical distinction. By calculating cash flows that are independent of how the company is financed, UFCF allows you to value the entire enterprise, not just the equity. This is why UFCF is discounted at the weighted average cost of capital (WACC), which reflects the blended cost of both debt and equity financing, and why the result is an enterprise value rather than an equity value.
The Unlevered Free Cash Flow Formula
Here is the standard UFCF formula used in investment banking:
Unlevered Free Cash Flow = EBIT x (1 − Tax Rate) + Depreciation & Amortization − Capital Expenditures − Change in Net Working Capital
Alternatively, you can start from EBITDA:
Unlevered Free Cash Flow = EBITDA x (1 − Tax Rate) + D&A x Tax Rate − Capital Expenditures − Change in Net Working Capital
Both approaches yield the same result. The first version (starting from EBIT) is more intuitive and more commonly used in interviews. Let us break down each component.
Breaking Down Each Component
EBIT (Earnings Before Interest and Taxes)
EBIT is the starting point because it measures operating profitability before the cost of debt (interest) and taxes. By starting with EBIT rather than net income, we ensure the cash flow calculation is independent of the company’s capital structure. Understanding how EBIT flows through the financial statements is essential: see our guide on how the three financial statements link together for a refresher.
Taxes: EBIT x (1 − Tax Rate)
We apply taxes directly to EBIT to calculate what is sometimes called NOPAT (Net Operating Profit After Tax) or EBIAT (Earnings Before Interest After Tax). This represents the after-tax operating earnings of the business.
Important: we are calculating taxes on EBIT, not on pre-tax income. In reality, the company’s actual tax bill is lower because interest expense is tax-deductible. But in the unlevered free cash flow calculation, we intentionally ignore the interest tax shield because we want a capital-structure-neutral cash flow. The tax benefit of debt is captured separately in the WACC discount rate.
Add Back: Depreciation and Amortization (D&A)
D&A is a non-cash expense. It reduces EBIT on the income statement but does not represent an actual cash outflow. Since we are calculating a cash flow metric, we add D&A back to EBIT after taxes (or equivalently, add back the tax shield on D&A if starting from EBITDA).
Note: if you start from EBITDA (which already excludes D&A), you do not add it back again: instead, you add back only the tax benefit of D&A (i.e., D&A x Tax Rate) because you over-taxed when you applied the tax rate to the full EBITDA.
Subtract: Capital Expenditures (CapEx)
Capital expenditures represent cash spent on long-term assets like property, equipment, and technology infrastructure. CapEx is a real cash outflow that is necessary to maintain and grow the business. It appears on the cash flow statement (investing activities) rather than the income statement, which is why it must be subtracted separately.
In a DCF model, you will typically project CapEx as a percentage of revenue or based on management guidance. The difference between maintenance CapEx (required to sustain current operations) and growth CapEx (required to expand) is important conceptually, though for UFCF purposes you subtract total CapEx.
Subtract: Change in Net Working Capital (NWC)
Net working capital is defined as current operating assets (primarily accounts receivable and inventory) minus current operating liabilities (primarily accounts payable and accrued expenses). The change in NWC represents cash that is either absorbed by or released from the company’s day-to-day operations.
- If NWC increases (e.g., receivables grow because customers are paying slower), the company is using more cash: this is a cash outflow and is subtracted.
- If NWC decreases (e.g., the company collects receivables faster or negotiates better payment terms with suppliers), cash is freed up: this is a cash inflow.
For growing companies, NWC typically increases over time, which is a drag on free cash flow. This is one of the reasons why a high-growth company’s free cash flow can be significantly lower than its reported earnings.
A Step-by-Step Numerical Example
Let us work through a concrete example to make this tangible.
Given:
- Revenue: $1,000 million
- EBITDA: $300 million
- D&A: $50 million
- EBIT: $250 million ($300M EBITDA − $50M D&A)
- Tax rate: 25%
- Capital expenditures: $60 million
- Change in NWC: +$20 million (NWC increased, so this is a use of cash)
Calculation (starting from EBIT):
- EBIT x (1 − Tax Rate) = $250M x 0.75 = $187.5M
- + D&A = $187.5M + $50M = $237.5M
- − CapEx = $237.5M − $60M = $177.5M
- − Change in NWC = $177.5M − $20M = $157.5M
Unlevered Free Cash Flow = $157.5 million
This $157.5 million is the cash generated by the business that is available to all capital providers before debt service.
Unlevered vs. Levered Free Cash Flow
This is one of the most commonly tested distinctions in investment banking interviews. Here is the key difference:
- Unlevered free cash flow (UFCF) is available to all capital providers (debt + equity). It excludes interest expense and debt repayments. It is discounted at WACC to arrive at enterprise value.
- Levered free cash flow (LFCF) is available only to equity holders. It includes the impact of interest expense (after tax) and mandatory debt repayments. It is discounted at the cost of equity to arrive at equity value.
The formulas:
Levered Free Cash Flow = Unlevered Free Cash Flow − Interest Expense x (1 − Tax Rate) − Mandatory Debt Repayments + Net New Borrowings
In investment banking, the UFCF approach (also called the “WACC method” or “enterprise DCF”) is far more common. The levered free cash flow approach (also called the “equity DCF” or “flow to equity” method) is used primarily in certain leveraged finance and private equity contexts. Understanding how to calculate the cost of equity is important for both approaches.
Why We Use Unlevered Free Cash Flow in a DCF
There are several reasons why UFCF is the standard in investment banking DCF models:
- Capital structure neutrality: UFCF values the underlying business regardless of how it is financed. This allows for clean comparisons across companies with different leverage levels.
- Consistency with WACC: UFCF is discounted at WACC, which captures the cost of both debt and equity. This approach is internally consistent because the cash flow and the discount rate both encompass all capital providers.
- Flexibility: Since the output is enterprise value, you can easily bridge to equity value by subtracting net debt. This is useful because capital structure can change over time or as a result of a transaction.
- Standard practice: This is simply how it is done in the industry. If you build a DCF in an investment banking context, you will use UFCF and WACC in the vast majority of cases.
Common Adjustments and Nuances
Beyond the basic formula, there are several adjustments you may encounter in practice or in more advanced interview questions:
Stock-Based Compensation (SBC)
SBC is a non-cash expense that reduces operating income but does not consume cash. Some practitioners add it back (treating it like D&A), while others argue it is a real economic cost because it dilutes existing shareholders. The most common approach in investment banking is to not add back SBC, i.e., treat it as a real expense, and separately account for dilution in the share count.
Deferred Taxes
In a more detailed model, you may use the company’s cash tax rate rather than the statutory rate. Deferred tax liabilities represent taxes that have been expensed on the income statement but not yet paid in cash, so the cash tax rate may differ from the book tax rate.
Other Non-Cash Items
Depending on the company, you may need to adjust for other non-cash items like impairments, gains/losses on asset sales, or non-cash restructuring charges. The goal is always the same: convert accrual-basis earnings into a true cash flow measure.
Common Interview Questions
“Walk me through how you calculate unlevered free cash flow.”
Start with EBIT, multiply by (1 − Tax Rate) to get after-tax operating income, add back D&A (non-cash), subtract CapEx, and subtract the change in net working capital. The result is the cash flow available to all capital providers before debt service.
“Why do we use unlevered free cash flow in a DCF instead of levered free cash flow?”
UFCF is capital-structure neutral, which allows us to value the underlying business independently of how it is financed. It pairs with WACC as the discount rate and produces enterprise value as the output. This is the standard approach in investment banking because it provides a clean, comparable valuation.
“What is the difference between unlevered and levered free cash flow?”
UFCF is cash available to all capital providers (debt + equity) before debt service. LFCF is cash available only to equity holders after interest and mandatory debt payments. UFCF is discounted at WACC to get enterprise value; LFCF is discounted at cost of equity to get equity value.
“Why do we add back depreciation?”
Depreciation is a non-cash expense. It reduces EBIT on the income statement but does not represent an actual cash outflow in the current period. Since we are calculating cash flow, we add it back. The actual cash impact of the underlying asset purchases is captured through CapEx.
“If a company’s net working capital increases, is that good or bad for free cash flow?”
Bad for free cash flow. An increase in NWC means the company is tying up more cash in its operating cycle (e.g., receivables growing, inventory building up). This is a use of cash that reduces free cash flow. However, it is often a sign of growth, so it is not inherently negative for the business, just for near-term cash generation.
Connecting UFCF to the Broader DCF Framework
Once you have projected UFCF for each year of the forecast period (typically 5-10 years), the next step in the DCF is to calculate the terminal value and discount everything back to the present. The terminal value, calculated using either the Gordon Growth Model or the exit multiple method, often represents 60-80% of the total enterprise value in a DCF. For a complete walkthrough of the DCF methodology, see our guide on how to walk through a DCF in an interview.
For more foundational technical topics, explore our free resources and technical cheatsheet. If you are earlier in your recruiting journey, make sure your resume and cover letter are polished before focusing exclusively on technicals.
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Related Articles
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- How to Calculate Cost of Equity: CAPM Formula
- Enterprise Value vs. Equity Value
- How the Three Financial Statements Link Together
- How to Explain an LBO: Leveraged Buyout Interview Question
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