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How do you calculate free cash flow?
Unlevered Free Cash Flow = EBIT × (1 - Tax Rate) + D&A - CapEx - Change in Net Working Capital. Levered Free Cash Flow = Net Income + D&A - CapEx - Change in NWC - Debt Repayments + Debt Issuances. Unlevered FCF is used in DCF; levered FCF shows cash to equity holders.
Why Interviewers Ask This
Free cash flow is the foundation of intrinsic valuation and the key metric that determines how much cash a business actually generates for its owners. Interviewers want to ensure you understand the difference between accounting profits and actual cash generation, and when to use each type of FCF.
How to Structure Your Answer
Define both unlevered and levered FCF, explain the formula components, and clarify when to use each. Emphasize the difference between accounting income and cash flow.
Key Points to Cover
- Unlevered FCF = EBIT × (1-T) + D&A - CapEx - ΔNWC
- Levered FCF = Net Income + D&A - CapEx - ΔNWC + Net Debt Change
- Unlevered FCF available to all capital providers
- Levered FCF available only to equity holders
- Use unlevered FCF with WACC in DCF
- Increasing NWC is a use of cash (negative)
- CapEx and D&A rarely equal - growth companies have CapEx > D&A
Sample Answer
Free cash flow represents the actual cash generated by a business that's available to distribute to capital providers. There are two main types.
Unlevered Free Cash Flow, also called Free Cash Flow to Firm, represents cash available to all capital providers - both debt and equity holders. The formula is: EBIT times one minus the tax rate, plus depreciation and amortization, minus capital expenditures, minus the change in net working capital.
Let me break this down: We start with EBIT and tax-effect it because this represents operating income available to all stakeholders before interest. We add back D&A because it's a non-cash expense that reduced EBIT. We subtract CapEx because that's a cash outflow required to maintain or grow the business. And we subtract the increase in net working capital because growth typically requires additional investment in working capital - more receivables and inventory, partially offset by payables.
Levered Free Cash Flow, or Free Cash Flow to Equity, represents cash available only to equity holders after debt obligations. The formula is: Net Income plus D&A, minus CapEx, minus change in NWC, minus debt repayments, plus any new debt issuances.
The key difference is that levered FCF accounts for interest expense (in net income) and debt service.
In DCF analysis, we use unlevered FCF discounted at WACC to get enterprise value. This is because unlevered FCF represents cash before financing decisions, and WACC represents the blended return required by all capital providers.
A common mistake is assuming that D&A equals CapEx - for mature companies in steady state this might be true, but growing companies typically have CapEx exceeding D&A.
Common Mistakes to Avoid
- Confusing levered and unlevered FCF
- Forgetting to tax-effect EBIT in the unlevered formula
- Getting the sign wrong on working capital changes
- Assuming D&A always equals CapEx
Pro Tip
Remember: increasing working capital is a use of cash, so it's subtracted. Think of it this way - if receivables go up, you've made sales but haven't collected the cash yet, so it reduces your available cash.
