Question

You have already completed an Unlevered DCF analysis but wanted to compare your valuations to that of a Levered DCF analysis. What is the general approach you would use?

A) Calculate Unlevered cash flows as before, but increase revenues/profits with additional leverage
B) Calculate Unlevered cash flows as before, but increase the leverage on the Net Debt when calculating implied Equity value
C) Adjust previous Unlevered cash flows by subtracting interest and discounting with the WACC to calculate Equity Value
D) Adjust previous Unlevered cash flows by subtracting interest and discounting with the Cost of Equity, and then subtract Net Debt for Equity Value
E) Adjust previous Unlevered cash flows by subtracting interest, adjusting taxes, and discounting with the Cost of Equity to calculate Equity Value

Answer 1

To compare a Levered DCF to an Unlevered DCF analysis, adjust the Unlevered cash flows by subtracting interest, use cost of equity to discount those cash flows, and then subtract net debt to find the Equity Value.

Step-by-step explanation:

When comparing valuations between an Unlevered DCF analysis and a Levered DCF analysis, the correct approach would be D) Adjust previous Unlevered cash flows by subtracting interest and discounting with the Cost of Equity, and then subtract Net Debt for Equity Value. In this approach, you start with the unlevered cash flows and adjust for the tax shield provided by the interest expense, since interest is tax deductible. Then, use the company's cost of equity to discount the cash flows, rather than the WACC used in an unlevered DCF because WACC incorporates the effects of both debt and equity financing, whereas, in a levered DCF, we are interested in valuing the equity directly. Finally, you subtract the net debt from the value obtained after discounting to arrive at the equity value.

In the levered DCF approach, it's important to factor in the tax savings from interest payments, as these change the cash flows available to equity holders. Additionally, the discount rate must reflect the risk posed to equity investors, which is why the cost of equity is used instead of WACC. Moreover, leveraging affects both the risk of the cash flows (due to the fixed interest payments) and the valuation (the equity value is the residual claim after debt).