Question

Let's say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow in your DCF - what is the effect?

a) Higher discount rate
b) Lower discount rate
c) No impact on the discount rate
d) No impact on the terminal value

Answer 1

Using Levered Free Cash Flow in DCF analysis leads to a higher discount rate than using Unlevered Free Cash Flow, due to the inclusion of the cost of debt and the required rate of return for equity holders.

Step-by-step explanation:

When you use Levered Free Cash Flow (LFCF) instead of Unlevered Free Cash Flow (UFCF) in your Discounted Cash Flow (DCF) analysis, the effect is a higher discount rate. This is because LFCF takes into account the cost of debt, as it is the cash flow available to equity holders after payments of interest and principal on debt have been made. As such, the discount rate used should reflect the equity holders' required rate of return, which is typically higher than the weighted average cost of capital (WACC) used in discounting UFCF, since equity is riskier than debt. The choice between leveraging or not affects the valuation method, but to say that it has an impact on the terminal value is incorrect. The terminal value calculation is based on assumptions about the long-term growth rate and discount rates, and these do not change simply because one is using LFCF instead of UFCF. Therefore, the correct answer to the student's question is (a) Higher discount rate.