Unlevered DCF
Executive Summary
Key Takeaways
- ✓ An unlevered DCF discounts FCFF, unlevered free cash flow, at WACC.
- ✓ FCFF is calculated independent of capital structure, so the resulting present value is enterprise value, not equity value.
- ✓ Enterprise value must be bridged to equity value by deducting net debt and other adjustments, and dividing by diluted share count.
- ✓ The unlevered approach is the most commonly used DCF structure, since it avoids the need to forecast the company's future debt schedule explicitly.
- ✓ Discounting FCFF at the cost of equity, rather than WACC, is one of the most common and consequential structural errors in DCF valuation.
Definition¶
An unlevered DCF is a DCF built around FCFF (unlevered free cash flow, or free cash flow to firm), which is the cash available to all capital providers — debt and equity holders combined — before any financing effects such as interest expense or debt repayment. Because FCFF is calculated independent of capital structure, it is discounted at WACC, producing enterprise value.
Why FCFF Is Discounted at WACC¶
FCFF represents cash flow available to all capital providers combined, not equity holders alone, since it is calculated before any deduction for interest expense or debt repayment. The appropriate discount rate for a cash flow stream is the blended return required by the holders of the claim on that cash flow — since FCFF is a claim shared by both debt and equity holders, it is discounted at WACC, which weights the cost of debt and the cost of equity by the target capital structure.
From Enterprise Value to Equity Value¶
Because FCFF excludes financing effects, the present value of an unlevered DCF's forecast is enterprise value — the value of the whole operating business — not equity value directly. Arriving at the value attributable to common shareholders requires a subsequent step: the enterprise-to-equity value bridge, deducting net debt, minority interests, and preferred stock, and adding back non-operating assets, before dividing by diluted share count. See Enterprise Value to Equity Value Bridge for the full methodology, and Levered vs. Unlevered DCF for a fuller comparison against the levered DCF alternative.
Why the Unlevered Approach Is More Common¶
The unlevered approach is the most widely used DCF structure in corporate valuation because it does not require forecasting the company's future debt schedule and interest expense in detail — WACC already captures the cost of debt through its capital-structure weighting, applied consistently across the forecast period. This makes the unlevered approach more tractable whenever a detailed, changing capital structure is not itself the central analytical focus, reserving the levered approach for cases such as leveraged buyout analysis where capital structure is central to the transaction's economics.
Audit Considerations¶
- Confirm FCFF is discounted at WACC, not the cost of equity or another levered rate
- Confirm FCFF genuinely excludes financing effects — interest expense and debt repayment should not appear in the FCFF build
- Confirm the resulting enterprise value is correctly bridged to equity value through a complete, disclosed set of adjustments, rather than being treated as equity value directly
- Confirm WACC's capital structure weights are based on target or market values, consistent with the FCFF build, not book values or an arbitrary assumption
Common Errors¶
| Error | Description | Risk |
|---|---|---|
| Discounting FCFF at the cost of equity | The unlevered cash flow is discounted at a levered rate rather than WACC | Produces a value that is neither a coherent enterprise value nor equity value |
| Treating enterprise value as equity value | The unlevered DCF's output is used directly as equity value without applying the bridge | Materially overstates or understates value attributable to shareholders |
| Financing effects embedded in FCFF | Interest expense or debt repayment is deducted within the FCFF build | Contaminates the unlevered cash flow, undermining the basis for discounting at WACC |
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Prerequisites¶
Related Glossary¶
Related Technical Guides¶
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Frequently Asked Questions
What is an unlevered DCF?
A DCF that discounts FCFF, unlevered free cash flow — the cash available to all capital providers, debt and equity holders combined, before financing effects — at WACC, the weighted average cost of capital, producing enterprise value.
Why is FCFF discounted at WACC rather than the cost of equity?
Because FCFF represents cash flow available to all capital providers combined, not equity holders alone. WACC blends the cost of debt and the cost of equity in proportion to the target capital structure, matching the discount rate to the combined claim represented by FCFF.
Does an unlevered DCF produce equity value directly?
No. It produces enterprise value, the value of the whole operating business attributable to all capital providers. Arriving at equity value requires a subsequent enterprise-to-equity value bridge — deducting net debt, minority interests, and preferred stock, and adding back non-operating assets.
Why is the unlevered approach more commonly used than the levered approach?
Because it does not require forecasting the company's future debt schedule and interest expense explicitly — WACC already captures the cost of debt through its capital-structure weighting. This makes the unlevered approach more tractable for most corporate valuations where a detailed, changing capital structure forecast is not the primary analytical focus.
What is the most common structural error in an unlevered DCF?
Discounting FCFF at the cost of equity instead of WACC. Since FCFF is deliberately capital-structure-independent, applying the levered cost of equity produces a value that is neither a coherent enterprise value nor equity value.
Related Articles
FCFF (Unlevered Free Cash Flow)
FCFF (Free Cash Flow to Firm), also called unlevered free cash flow, is the cash a business generates that is available to all of its capital providers — both debt and equity holders — before any financing effects such as interest payments or debt repayment. FCFF is built from NOPAT by adding back non-cash charges and deducting capital expenditure and working capital investment. Because FCFF is calculated independent of capital structure, it is discounted at the weighted average cost of capital (WACC), and the resulting present value is enterprise value — the value of the operating business before deducting net debt to arrive at equity value.
Levered DCF
A levered DCF is a DCF built around FCFE, levered free cash flow, which is the cash remaining for common equity holders after all operating expenses, capital expenditure, working capital investment, interest expense, and net debt repayment. Because FCFE already reflects the effect of the company's capital structure and financing activity, it is discounted at the cost of equity, the return required by equity holders specifically, rather than a blended cost of capital. The present value of a levered DCF's forecast produces equity value directly, without the enterprise-to-equity bridge required after an unlevered DCF.
Levered vs. Unlevered DCF (FCFE vs. FCFF)
Unlevered DCF and levered DCF are the two structural variants of discounted cash flow valuation, distinguished by which cash flow is forecast and which discount rate is applied to it. Unlevered DCF forecasts free cash flow to the firm (FCFF) and discounts it at the weighted average cost of capital (WACC) to reach enterprise value, which is then bridged down to equity value. Levered DCF forecasts free cash flow to equity (FCFE) and discounts it at the cost of equity, reaching equity value directly without a separate bridge. Both are internally consistent methods when the cash flow basis and discount rate are correctly matched; mismatching the two — discounting FCFF at the cost of equity, or FCFE at WACC — is one of the most consequential and common errors in DCF construction.
WACC (Weighted Average Cost of Capital)
WACC (Weighted Average Cost of Capital) is the rate of return that a company must earn on its existing assets to maintain the value of its equity and satisfy both its debt holders and equity investors. It is calculated as the weighted average of the after-tax cost of debt and the cost of equity, with the weights determined by the proportion of each in the total capital structure. WACC is used primarily as the discount rate in a discounted cash flow (DCF) valuation, where it converts projected free cash flows into present value. It is also used as a return hurdle: a project or investment is value-creating if its expected return exceeds the WACC.