How to Answer “What is the difference between unlevered free cash flow and levered free cash flow?” in Investment Banking Interviews
In investment banking interview prep, this is one of the most common cash flow prompts: “What is the difference between unlevered free cash flow and levered free cash flow?” A strong answer is not just definitions—it shows you understand who the cash flow belongs to, what gets deducted, and where each metric is used in valuation.
At analyst level, interviewers want you to be crisp on the mechanics (interest, debt paydown/issuance, and taxes) and to connect each cash flow to the right valuation method (enterprise value vs equity value) and the right discount rate (WACC vs cost of equity).
What This Tests in Investment Banking Technical Questions
First, they’re testing whether you can keep the capital structure straight. Many candidates can recite a formula, but get confused on whether interest is included, whether debt changes are included, and what “after debt” really means.
Second, they’re testing valuation mapping: unlevered free cash flow should naturally lead you to a DCF that produces enterprise value and uses WACC. Levered free cash flow should lead you to equity value and a discount rate closer to the cost of equity. If you can state this cleanly, you signal you can build and interpret models.
Third, they’re testing communication under pressure on investment banking technical questions: can you give a two-sentence headline, then add detail only if asked (e.g., how taxes change with interest, and what happens when debt is issued or repaid).
Unlevered vs Levered Free Cash Flow: A 4-Step Answer Framework
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Step 1: Give a one-sentence headline (who the cash flow is for)
Start with ownership of the cash flow.
- Unlevered free cash flow (UFCF) is cash flow available to all capital providers (debt and equity) before debt financing effects.
- Levered free cash flow (LFCF) is cash flow available to equity holders only after servicing debt.
This “claimholder” framing is the cleanest levered free cash flow explanation and prevents you from mixing up enterprise value vs equity value later in the answer.
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Step 2: State the key formula differences (interest and net debt changes)
Next, anchor the difference with the specific line items.
A practical unlevered free cash flow definition is:
- UFCF ≈ EBIT × (1 − tax rate) + D&A − Capex − ΔNWC
Levered free cash flow then adjusts for financing:
- LFCF ≈ Net income + D&A − Capex − ΔNWC + net borrowing
Equivalently, starting from UFCF:
- LFCF = UFCF − after-tax interest expense + net borrowing (debt issued − debt repaid)
Call out the intuition: levered cash flow subtracts the cash cost of debt (interest and required repayments) but can increase if the company raises incremental debt.
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Step 3: Connect each metric to valuation outputs and discount rates
Now link the metric to its “correct” valuation framework.
- UFCF → DCF to Enterprise Value (EV), discounted at WACC, because the cash flows are pre-financing and belong to both debt and equity.
- LFCF → DCF to Equity Value, discounted at the cost of equity, because the cash flows are after debt obligations and belong only to equity.
A good analyst-level add-on: if you value using UFCF and get EV, you reconcile to equity value by subtracting net debt (and other non-operating items). This is often the hidden point in investment banking interview questions on cash flow.
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Step 4: Add quick sanity checks and edge cases (what changes, what doesn’t)
Close with 2–3 “checks” that show judgement.
- If a company takes on more debt this year, levered FCF can rise (cash inflow from borrowing) even if operations are unchanged; unlevered FCF should not change from financing decisions.
- Interest affects taxes (interest tax shield), which is why UFCF typically uses EBIT after tax (taxes as if unlevered), while LFCF is inherently impacted by actual interest.
- In highly levered situations, LFCF can be volatile or negative even when the business generates strong operating cash flow—because debt service is senior.
These points help you deliver the “difference between unlevered and levered free cash flow explained” without over-formulaic memorisation.
Analyst-Level Model Answer (Say-It-Out-Loud)
Unlevered free cash flow is the cash flow available to all providers of capital, before financing effects. Levered free cash flow is the cash flow left for equity holders after servicing debt.
More specifically, unlevered free cash flow is typically calculated as EBIT × (1 − tax rate) + D&A − Capex − change in net working capital. It excludes interest expense and excludes debt issuance or repayment because it’s meant to be independent of capital structure.
Levered free cash flow reflects financing, so it’s closer to net income + D&A − Capex − change in NWC, and then you incorporate net borrowing. Another way to think about it is: LFCF = UFCF − after-tax interest expense + net borrowing.
In valuation, that mapping matters: UFCF is discounted at WACC to get enterprise value in a DCF, and then you bridge from enterprise value to equity value by subtracting net debt and other adjustments. LFCF is discounted at the cost of equity to get equity value directly, since it already reflects debt servicing.
As a sanity check, if a company issues more debt, levered free cash flow can increase from the cash inflow, but unlevered free cash flow shouldn’t change because the business’s operating cash generation hasn’t changed.
- Lead with the claimholder distinction (all capital vs equity) before any formulas.
- Use one clean formula for each; avoid listing five equivalent variants unless asked.
- Explicitly connect UFCF→EV/WACC and LFCF→equity value/cost of equity.
- Add one quick sanity check (e.g., debt issuance affects LFCF, not UFCF) to show understanding.
- Keep terminology consistent: enterprise value vs equity value, not “firm value” vs “share value” interchangeably.
Common Mistakes in Cash Flow and Valuation Explanations
- Saying unlevered FCF is “before interest” but then starting from net income (which is already after interest).
- Forgetting **net borrowing** when describing levered free cash flow, or treating debt principal repayment as the same thing as interest.
- Discounting levered cash flows at WACC (mixing an equity cash flow with a blended discount rate).
- Claiming UFCF is “cash flow to equity” because it’s “free cash flow” (missing the all-capital-providers point).
- Ignoring taxes: UFCF uses taxes as if unlevered (EBIT after tax), while LFCF reflects the interest tax shield implicitly.
- Overcomplicating with accounting noise (e.g., listing every non-cash item) instead of clearly stating the conceptual difference.
Follow-Ups on DCF, WACC, and Equity Value Bridging
When would you use levered free cash flow instead of unlevered free cash flow?
When you specifically want an equity value directly (e.g., an equity DCF) and you have a credible forecast for the company’s debt schedule and borrowing needs.
Why do we discount unlevered free cash flow at WACC?
Because UFCF belongs to both debt and equity, so the discount rate should reflect the required return of the entire capital structure—i.e., the weighted average cost of capital.
How do you go from enterprise value to equity value in an unlevered DCF?
Take enterprise value and subtract net debt (and adjust for non-operating items like cash, investments, minority interests, pensions, etc.) to arrive at equity value.
Does higher leverage always mean higher levered free cash flow?
Not necessarily—more leverage increases interest and required repayments, which can reduce LFCF even if the business is performing well operationally.
Where does the interest tax shield show up in UFCF vs LFCF?
UFCF typically excludes interest and uses EBIT after tax (taxes as if unlevered), while LFCF reflects actual interest expense, so the tax shield is embedded in net income and cash taxes.
How to Prepare for Investment Banking Technical Interviews
- Practise a 20-second version first: “UFCF is pre-financing cash flow to all capital; LFCF is post-debt cash flow to equity.” Then add formulas and valuation mapping only if prompted.
- Drill the mapping: UFCF → WACC → EV and LFCF → cost of equity → equity value. If you can’t say this cleanly, revisit your DCF logic.
- Use one sanity-check example in your head (e.g., “issue £100 of debt—LFCF goes up today, UFCF doesn’t”) to stay calm under pressure.
- Rehearse out loud with AceTheRound and focus on eliminating filler words while keeping the same structure each time.
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