A company can report rising earnings while consuming cash. Projecting unlevered free cash flow captures what remains after taxes and reinvestment; bridging enterprise value to equity value then identifies whose claim you have valued.
You use discounted cash flow (DCF) analysis to estimate today's value of future cash receipts. Discounting recognizes that investors require compensation for waiting and bearing risk. Your revenue growth and operating assumptions determine the cash available. Your discount rate translates those future amounts into present dollars.
Start by projecting unlevered free cash flow: the cash that operations generate after taxes and reinvestment, before payments to lenders or shareholders. “Unlevered” means the calculation removes financing effects. It lets you value operations without making the operating forecast depend on the company's existing borrowing arrangements.
Earnings before interest and taxes (EBIT) measures operating profit before financing costs and income taxes. Projecting unlevered free cash flow starts with EBIT because interest-bearing debt should not reduce cash available to all capital providers.
Common mistakes
- Reversing the working-capital sign. In Example 1, adding the $6 million increase produces $32 million of cash flow instead of $20 million.
- Using pretax debt cost. Example 1's unadjusted 8% debt cost produces 60% × 13% + 40% × 8% = 11% WACC, rather than 10.2%.
- Using book-value financing weights. If equity's book value is $200 million but its market value is $600 million, use $600 million in WACC.
Bottom line
- Unlevered free cash flow equals after-tax EBIT plus D&A minus capex minus the change in operating net working capital.
- Operating net working capital excludes cash and interest-bearing debt.
- WACC combines CAPM cost of equity and after-tax cost of debt using market-value financing weights.
- Gordon terminal value uses next-period cash flow and requires growth below WACC; exit multiples produce an alternative terminal estimate.
Exam shortcut
Mark the cash-flow recipient first: all capital providers or common shareholders. That choice identifies the discount rate and whether an equity bridge remains. Circle timing words: “just paid,” “final forecast year,” and “next year.” Grow a historical or final-year amount once; use an already-forward numerator directly. Draw a terminal-date box. Put final-year cash flow and terminal value inside it, then apply their shared discount factor. Keep units beside each calculation.
The full lesson (about 3,721 words, 25 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- A8
Browse all free Series 79 lessons or jump into free Series 79 practice questions.