The FCFF Levered Debt formula is a form of Adjusted Present Value (APV) valuation. In APV valuation, the value of a levered firm is obtained by adding the net effect of debt to the unlevered firm value.
The difference between levered and unlevered free cash flow is expenses. Levered cash flow is the amount of cash a business has after it has met its financial obligations. Unlevered free cash flow is the money the business has before paying its financial obligations. Operating expenses and interest payments are examples of financial obligations that are paid from levered free cash flow.
Even if a company's FCFE with levered debt is negative, it does not necessarily indicate that the company is failing. It may be the case that the company has made substantial capital investments that have yet to begin paying off at the level the company expects. As long as the company is able to secure the necessary cash to survive until its cash flow increases due to increased revenues, then a temporary period of negative levered free cash flow is both survivable and acceptable.
What a company chooses to do with its levered free cash flow is also important to investors. With this in mind, investors are able to calculate the Free Cashflow to Firm with Levered Debt using the formula depicted above and the variables below.
The expected free cashflow to firm for this year/current year. This value is used to calculate all FCFF payments in the future when coupled with the growth rate (g).
The assumed rate of continuous growth maintained by the company being evaluated with the FCFF Levered Debt formula. This assumption of continuous growth maintained by a firm is used to calculate a fair value for a firm with levered debt.
The unlevered rate of return on investments or cashflows to the firm. This value is effectively the rate of return or discount rate but without levered debt considerations attached to it.
The company tax rate paid by the company in its country of operation. This tax rate is subject to the tax rate required by government for companies to pay on its earnings.
The market value of debt is the value of debt held by the firm. It is the amount of firm capital financing held by the firm in which the firm pays interest to a lender such as a bank or other financial institutions.
The probability of default of a firm after taking on additional debt. This is the probability that a firm will enter into administration or bankruptcy when taking on more debt as opposed to equity, effectively changing its capital structure.
The present value of bankruptcy costs to firm should the firm go bankrupt. This is the value the firm will pay should it default on its financial debt commitments.
The adjusted present value of free cashflow to a firm after leveraging for the net effects of debt. This is the final value calculated by the FCFF Levered debt formula that allows investors to better interpret the financial position of the firm being evaluated, giving investors a value to use when making investment decisions.
The final value of FCFF with Levered Debts after taking into account all debt and financial obligation considerations. This value is interpreted by investors for the purpose of making more informed investment decisions regarding the company under analysis.
Consider a company with a Free Cashflow to Firm value (FCFF0) of $5,000,000 this year, a growth rate (g) of 5%, an unlevered rate of return (ρU) of 12.5%, and a company tax rate (TC) of 30%. This company also has a market value of debt (D) of $10 million, a probability of default (πa) of 20%, and a bankruptcy cost (BC) of $15 million. Using the FCFF Levered Debt formula, an investor can calculate the Levered Value of FCFF as follows:
Vlev = (FCFF0 * (1+g)) / (ρU - g) + TC*D - πa*BC
Vlev = (5,000,000 * (1+0.05)) / (0.125 – 0.05) + 0.3*10,000,000 – 0.2*15,000,000
Vlev = $70,000,000
After accounting for debt factors and leveraging the FCFE Value of a firm, an investor can calculate the value of Vlev to be $70,000,000.
Levered free cash flow is important to both investors and company management, because it is the amount of cash that a company can use to pay dividends to shareholders and/or to make further investments in growing the company's business. The ability for investors to calculate the levered debt value of free cashflows to a firm allows investors to make better informed investment decisions regarding the company under analysis.
Levered free cash flow is also a measure of a company's ability to expand its business using only the money generated through current operations. It may also be used as an indicator of a company's ability to obtain additional capital through financing, either via lenders like banks or through investors through IPOs.
Free Cashflow to Firm with Levered Debt is the money that is left over when all the bills from a company's operations are paid. A company can have a negative levered free cash flow even if operating cash flow is positive. A company may choose to use its levered free cash flow to increase dividends to investors, buy back stock or reinvest in the growth of the business. Investors can calculate the FCFE Levered Debt value of a firm from reviewing the balance sheet and income statement of a firm to determine whether the company is stable enough to invest in.
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