Why Levered FCF?

First, it WILL come up in interviews. Common questions:

-How are Levered FCF and Unlevered FCF different from each other?
-How does a Levered DCF analysis differ from an Unlevered one?
-Will both types of DCFs give you the same implied share price?
BUT it's frequently misunderstood. Levered FCF, AKA Free Cash Flow to Equity, is a "theoretical" concept
that is rarely practical to use in real life.
Levered FCF vs. Unlevered FCF
Levered FCF is much closer to a company's real Cash Flow Statement, whereas Unlevered FCF has
more adjustments and excludes line items related to capital structure (interest income, interest expense,
debt repayments and issuances, etc.).
From the top of the CFS, Levered FCF starts with exactly what's in the Cash Flow from Operations
section.
Whereas with Unlevered FCF, you adjust and use EBIT * (1 -- Tax Rate), otherwise known as NOPAT,
instead of Net Income.
The Cash Flow from Investing section is largely the same -- you exclude everything except for CapEx,
and only project that in future periods.
Finally, for Unlevered FCF you eliminate the last section of the CFS completely because you're
purposely ignoring the company's capital structure -- plus, most of the items there are nonrecurring anyway.
With Levered FCF, though, you eliminate most of the line items there... but you KEEP the ones related to
debt repayments (some people also argue you should keep debt issuances).
Other Differences in the Analysis Itself:
With Levered FCF, you use Cost of Equity for the discount rate; with Unlevered FCF you use
Weighted Average Cost of Capital (WACC). Cost of Equity is almost always higher for companies
that carry any amount of debt.
Also, with Levered FCF you calculate the implied Equity Value directly at the end when you add
the NPV of cash flows to the NPV of the Terminal Value; with Unlevered FCF, you calculate
Enterprise Value and then must back into Equity Value by subtracting debt and adding cash.
The Problems with Levered FCF:
Problem #1: First, it often requires a lot more work because you need to project how the company's
debt and cash balances change over time... and doing so often requires a full 3-statement model.

Problem #2: Often, the Levered FCF numbers are much more "volatile" than the Unlevered FCF
numbers because debt payments fluctuate greatly from year to year.
Problem #3: You will NOT get the same result by using Levered FCF -- anything can throw off the
numbers, from interest rate changes to changes in debt repayment schedules to equity/debt
issuances.
Problem #4: Ambiguous definitions -- Different people define Levered FCF differently. Net interest
expense is always subtracted...
BUT do you subtract *all* debt repayments? Or just mandatory debt repayments? Do you add debt
issuances?
Bottom-line: Using Unlevered FCF is easier, less time-consuming, less ambiguous, and gets you more
consistent numbers.
Are There Any Cases Where Levered FCF Might Be Helpful Anyway?
You may use it if the company's capital structure is changing significantly, in
restructuring/bankruptcy scenarios, and for certain industries such as REITs (real estate
investment trusts) where debt issuances and repayments happen consistently from year to year.