Unlevered VS Levered FCF
Considering this explanation and the definition of WACC which takes the entire capital structure into account, you will have to use Unlevered FCFs for your DCF analysis.
If you are comparing companies with different capital structures, or valuing a project or division within a company, you should use unlevered beta. If you are estimating the required return of equity investors, or valuing a company with a target capital structure, you should use levered beta.
In an LBO analysis, however, we are looking at everything from the value attributable to the Equity Investor (a Private Equity firm in this case). And Equity Value sits below Debt in the capital hierarchy. As a result, we look at Levered Free Cash Flow, which incorporates the impact of Debt.
The DCF model relies on free cash flow (FCF), which is a reliable metric that reduces the noise created by accounting policies and financial reporting.
You should use the unlevered FCF when valuing a company using the DCF method when you are interested in valuing the firm as a whole.
FCFF is often discounted by weighted average cost of capital (WACC), while FCFE is discounted by cost of equity. Both FCFF and FCFE are used when doing a DCF.
Unlevered Free Cash Flow (UFCF) is a critical component in financial modeling and valuation, as it serves as the basis for assessing a company's worth. UFCF provides a measure that is independent of capital structure, facilitating comparison between firms with different financing arrangements.
The Rule of 72 in Paper LBOs
The approximate number of years necessary for the investment value to double in size can be determined by dividing 72 by the rate of return.
LBO or DCF depends on investment goals and transaction type. We use LBOs to acquire a company, enhance its performance, and then sell it for a higher price. However, DCF can estimate the intrinsic value of stocks, bonds, and real estate for long-term investment decisions.
Unlevered Beta and Accuracy
Since a security's unlevered beta is naturally lower than its levered beta due to its debt, its unlevered beta is more accurate in measuring its volatility and performance in relation to the overall market.
An unlevered capital structure is one that is entirely made up of equity and the WACC will reflect that! A levered capital structure is one that is made up of any combination of debt and equity and the WACC will reflect that! In a levered capital structure setting, the risk put in the firm goes up and so does the WACC!
Levered beta (commonly referred to as just beta or equity beta) is a measure of market risk. Debt and equity are factored in when assessing a company's risk profile. Unlevered beta strips off the debt component to isolate the risk due solely to company assets.
There are two types of Free Cash Flows: Free Cash Flow to Firm (FCFF) (also referred to as Unlevered Free Cash Flow) and Free Cash Flow to Equity (FCFE), commonly referred to as Levered Free Cash Flow.
So, what is DCF modeling? It uses a series of factors, including EBITDA (or earnings), in order to arrive at the future value of the investment. In most instances, the DCF valuation method is used when valuing privately held companies; however, in some cases, it's used in publicly held companies that issue stock.
DDM vs. DCF Valuation: What is the Difference? The dividend discount model (DDM) states that a company is worth the sum of the present value (PV) of all its future dividends, whereas the discounted cash flow model (DCF) states that a company is worth the sum of its discounted future free cash flows (FCFs).
The Rule of 72 is a simple way to estimate how long it will take your investments to double by dividing 72 by your expected annual return rate. Higher-risk investments like stocks have historically doubled money faster (around seven years) compared with lower-risk options like bonds (around 12 years).
Rule of 144: This rule states how long it will take your money to quadruple or gain four times with a fixed interest rate.
The Rule of 69 is a simple calculation to estimate the time needed for an investment to double if you know the interest rate and if the interest is compounded. For example, if a real estate investor earns twenty percent on an investment, they divide 69 by the 20 percent return and add 0.35 to the result.
An Unlevered DCF is easier to set up and produces more consistent results that depend far less on a company's capital structure. There are a few specialized cases where a Levered DCF might be helpful (e.g., with Equity REITs), but 99% of the time, the Unlevered DCF is superior.
EBITDA in Financial Modeling
EBITDA is used frequently in financial modeling as a starting point for calculating unlevered free cash flow.
The cash flow generated by the investment property remains relatively identical regardless of the financing structure, yet the equity contribution from the investor is lower if debt is used to finance the transaction. Hence, the levered IRR of an investment property exceeds the unlevered IRR in practically all cases.
FCFE = CFO – FCInv + Net borrowing. FCFF can also be calculated from EBIT or EBITDA: FCFF = EBIT(1 – Tax rate) + Dep – FCInv – WCInv. FCFF = EBITDA(1 – Tax rate) + Dep(Tax rate) – FCInv – WCInv.
The Weighted Average Cost of Capital (WACC) is one of the key inputs in discounted cash flow (DCF) analysis, and is frequently the topic of technical investment banking interviews.
Between the FCFF vs FCFE vs Dividends models, the FCFE method is preferred when the dividend policy of the firm is not stable, or when an investor owns a controlling interest in the firm.