Why do you use unlevered free cash flow in a DCF?

Unlevered free cash flow is the cash available to all capital providers, before any interest payments. It pairs with WACC, which already blends the cost of debt and equity. If you discounted levered cash flow (after interest) at WACC you would count the cost of debt twice — levered cash flow belongs with cost of equity instead.

What discount rate do you use and why?

WACC — the weighted average cost of capital. It blends the cost of equity, usually from CAPM (risk-free rate plus beta times the equity risk premium), with the after-tax cost of debt, weighted by the proportions of each in the capital structure. The after-tax figure is used for debt because interest is tax-deductible.

How do you calculate terminal value?

Two methods. Perpetuity growth: take the final projected year's free cash flow, grow it at a modest perpetual rate (typically 2–3%, below long-run GDP growth) and divide by WACC minus that growth rate. Exit multiple: apply a comparable-company EBITDA multiple to terminal-year EBITDA. Both are then discounted back to today. Most analysts run both as a cross-check.

Why is terminal value such a large share of the total?

Because it captures every year beyond the explicit forecast — potentially forever — while the projection period captures only five to ten. It commonly represents 60 to 80% of total enterprise value. This is the honest weakness of a DCF: most of the answer comes from the input you are least able to forecast.

What would increase a company's DCF value?

Higher projected free cash flows, a lower discount rate (lower beta, lower risk-free rate, or more cheap debt in the capital structure), or a higher terminal growth rate or exit multiple. Interviewers often ask this to check you understand that the discount rate and the growth rate pull in opposite directions.

When is a DCF the wrong tool?

When cash flows cannot be forecast with any confidence — early-stage companies, deeply cyclical businesses at a turning point, or financial institutions, where interest is operating revenue rather than a financing cost and the unlevered framework breaks down. Banks and insurers are usually valued on dividend discount or residual income models instead.

Walk Me Through a DCF — The Interview Answer

The most predictable question in an investment banking interview. Here is the ninety-second answer, the detail to hold in reserve, and the follow-ups that catch people out.

If you get one technical question in an investment banking interview, it is this one. It is asked constantly, not because a DCF is hard, but because it is a compact test of whether you can hold a multi-step process in your head and explain it in order.

The ninety-second answer

“A DCF values a business as the present value of the cash it will generate. I’d project unlevered free cash flow for five to ten years — that’s EBIT, taxed, plus D&A, less capex and less the change in working capital. I’d discount those flows back at WACC, the blended cost of the company’s debt and equity.

Because the business doesn’t stop at year five, I’d add a terminal value — either growing the final year’s cash flow at a modest perpetual rate, or applying an exit multiple to terminal-year EBITDA — and discount that back too.

Summing the discounted flows and the discounted terminal value gives enterprise value. From there I’d subtract net debt to get equity value, and divide by diluted shares for a per-share figure. Happy to go deeper on any step.”

That is the whole answer. Give the skeleton first and offer the detail — do not start enumerating working capital line items unprompted.

What the interviewer is actually listening for

Three things, in roughly this order.

Order. Cash flows, then discount rate, then terminal value, then the bridge to equity. Candidates who jump straight to terminal value, or who forget the bridge entirely, signal that they have memorised fragments rather than understood a process.
Unlevered, not levered. Saying “free cash flow” without the word unlevered invites an immediate follow-up. Unlevered FCF is before interest, which is why it pairs with WACC — a rate that already accounts for the cost of debt. Mixing levered cash flow with WACC double-counts the financing.
That you know it is an estimate. A DCF is enormously sensitive to two inputs you are guessing at: the discount rate and the terminal growth rate. Candidates who present it as precise are revealing they have never built one.

The steps, in slightly more detail

1. Project unlevered free cash flow

Start from EBIT, apply the tax rate to get net operating profit after tax, add back non-cash charges like depreciation and amortisation, then subtract capital expenditure and the increase in net working capital. What is left is the cash available to all capital providers, debt and equity alike.

2. Discount at WACC

WACC blends the cost of equity and the after-tax cost of debt, weighted by their share of the capital structure. Cost of equity usually comes from CAPM: the risk-free rate plus beta times the equity risk premium. Debt is cheaper because interest is tax-deductible — which is exactly why the after-tax cost is the one that belongs in the formula.

3. Add a terminal value

Two accepted methods. Perpetuity growth takes the final projected year’s cash flow, grows it at a rate below long-run GDP growth — typically 2 to 3% — and capitalises it at (WACC minus g). Exit multiple applies a comparable-company EBITDA multiple to the terminal year. Most banks run both and sanity-check one against the other.

Expect terminal value to be 60 to 80% of your total. That is normal, and it is also the honest reason a DCF is more of a framework for thinking than a precision instrument.

4. Bridge to equity value

Enterprise value belongs to everyone who funded the business. Subtract debt, add cash, adjust for minority interests and preferred stock, and you have the value attributable to common shareholders. Divide by diluted shares for a price per share you can compare to where the stock actually trades.

Say this, not that

“Unlevered free cash flow discounted at WACC” — not just “cash flow”.
“Terminal growth below long-run GDP” — a 5% perpetual growth rate implies the company eventually becomes the economy.
“Enterprise value, then bridge to equity” — naming the bridge shows you know they are different numbers.

Walk me through a DCF