6. Unlevered Free Cashflow

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Many different types of cashflow exist in a company, from operating cashflows to free cashflow to equity. In this lesson, I'll show you why unlevered free cashflow is a very important cashflow for valuation.


Getting to Equity Value

- To get to Equity Value for a company, it's often easier to find Enterprise Value first
- The cashflows that will be discounted for Enterprise Value, are not found directly from projections
- Instead we need to perform some calculations to find unlevered free cash flow

Unlevered Free Cashflow

- This cashflow captures the cash generated by the business for both debt and equity holders
- As a result, we need to first remove the impact of any interest repayments
- This will also include any tax shield that interest payments provide
- Consequently, a company will often have higher tax under this cashflow model

Steps to Calculating Unlevered Free Cashflow

1. Begin with EBIT and subtract taxes from this number
2. Add back depreciation & amortisation
3. Adjust for changes in working capital
4. Adjust for changes in capital expenditure


Now that we've discussed discount rates, enterprise value, and the different valuation methods, let's move to Excel and start working on the financial model for MarkerCo. In the previous course, we created five year financial statement projections for the income statement, balance sheet, and cashflow statement. As you can imagine, when using the discounted cash flows valuation method we need to examine the cashflow statement of the business. This brings up an important question. Which cashflow do we actually discount? Is it the cashflow from operating activities, investing activities, financing activities, or a combination of the three? Well ultimately it depends on how we want to value the company. Our final valuation will be equity value which will be the value of the shares. However to first get there I find it easier to go to enterprise value first then subtract the debt, add back the cash, and then get to equity value. So the cashflows we're going to discount in our financial model will be the cashflows to both the equity holders and the debt holders. This essentially means the cashflow from operations to both equity and debt holders and the capital expenditures. Which is typically the acquisition of PP&E. This particular cashflow is called the unlevered free cashflow. Leverage relates to debt. Levered free cashflows are free cashflows that take into account debt. Unlevered free cashflows include the cashflows to equity holders and debt holders. We need to strip out the impact of interest expense from our cashflow calculations. To do this I have set up a separate section underneath my statement of cashflows entitled unlevered free cashflow. To calculate the unlevered free cashflows we start with EBIT, which is the operating income before interest and tax payments. EBIT are pretax earnings available to equity and debt holders because interest hasn't been subtracted yet. I simply connect this cell to the cell in the income statement, which is here. I'll copy across for the remaining cells holding the title.

Now I need to subtract taxes which is going to be the operating income multiplied by minus the tax rate which is also in the income statement. Here we go.

And I'll copy across.

This allows me to calculate net operating profit after tax. Essentially this NOPAT figure is the net profit after stripping out the effects of interest. I simply add these two values together.

Given that MarkerCo has no long term debt, I would expect NOPAT to be the same as net profit. Let's skip up to the cashflow statement quickly and check this. In 2020, net profit should be 25.0.

When I skip up I can see that this is the case. You might be tempted to simply use net profit in the unlevered free cashflow calculations because there's no debt on MarkerCo. However, we may run a scenario where we do add some debt on to MarkerCo and then our unlevered free cashflows would need to be updated accordingly. It's much easier to build the formulas correctly at the beginning and allow for scenarios such as including debt on MarkerCo's balance sheet. Once you've calculated NOPAT, we then need to make the same adjustments that we made in the operating cashflows from the statement of cashflows. These include depreciation and amortization changes and changes in operating assets and liabilities. To save some time, I'm going to do this off camera underneath NOPAT.

I now have the same adjustments for non cash charges and changes in operating assets and liabilities in my unlevered free cashflow section as I do in my statement of cashflow section. For my formulas I simply link directly to the statement of cashflows.

Underneath these adjustments, I also subtract net capital expenditures to find my unlevered free cashflows. To do this I simply add my net capital expenditures, my total adjustments and changes, and NOPAT.

Then copy across for the remaining cells. This gives me my annual unlevered free cashflows for MarkerCo.

In the next lesson, we'll calculate the discount rate for MarkerCo and apply this discount rate to the unlevered free cashflows.