In a discounted cash flow analysis, what is the nature of free cash flow that is used?

• A. Levered (includes debt and interest)
• B. Unlevered (debt-free)
• C. Depends on the company’s capital structure
• D. Irrelevant to valuation

Answer: (B)

In a discounted cash flow analysis, you value the business by cash flows generated from operations before any financing decisions. This means using unlevered free cash flow (free cash flow to the firm), which excludes debt and interest payments and represents cash available to all capital providers. By projecting these operating cash flows and discounting them at the firm’s overall cost of capital (the WACC), you arrive at the enterprise value of the business, independent of its capital structure.

Using levered cash flow would mix in debt service and financing effects, and would require a different discount rate (cost of equity) to value equity rather than the whole firm. That’s not the standard enterprise-value approach. The other options misstate the relationship between financing and cash flows or mischaracterize what’s used in a cash-flow DCF.