What is the effect of using levered free cash flow instead of unlevered cash flow in a DCF?

• A. Levered FCF yields equity value rather than enterprise value.
• B. Levered FCF yields enterprise value.
• C. They yield the same value.
• D. Levered FCF is only for LBOs.

Answer: (A)

Levered free cash flow represents cash flow after debt service, so it belongs to equity holders. When you value those cash flows, you are estimating the equity value of the firm, and you should discount them with the cost of equity. In contrast, unlevered free cash flow is cash flow before financing decisions and is available to all capital providers, so discounting UFCF at the weighted average cost of capital yields enterprise value. Therefore, using levered FCF in a DCF gives equity value, not enterprise value. It's not exclusive to LBOs; levered FCF can be used outside LBOs if you apply the appropriate discount rate and interpretation.