DCF Valuation: Financial leverage and the debt tax shield

DCF valuation models can either be based on free cash flow attributable to equity investors or the free cash flow available for all providers of finance. Each requires a different approach to allowing for financial leverage, including adjustments to beta and recognition of the debt interest tax shield.   

We present an interactive DCF model that illustrates discounted equity cash flow and discounted enterprise cash flow using both the WACC and APV methods. Understanding each approach helps in ensuring consistent valuations, whichever method you choose to adopt.

Discounted cash flow valuations can be derived in different ways depending on (1) how free cash flow is defined and therefore how financial leverage is reflected in the valuation; and (2) how the tax effects of debt and equity financing are dealt with. Combining these factors produces the three DCF approaches that are commonly applied in practice:

  • Discounted equity free cash flow
  • Discounted enterprise free cash flow – APV method
  • Discounted enterprise free cash flow – WACC method

Each approach must give the same result if based on consistent underlying value drivers and assumptions. However, it is easy to be inconsistent and therefore produce incorrect valuations. 

DCF valuations can be mis-stated if cash flow and cost of capital calculations are inconsistent

We have often come across analyst models that appear to incorrectly mix elements of both an enterprise and equity approach, or which fail to consistently deal with financial leverage. For example, when using an equity free cash flow model, it is important to include the forecast debt cash flow, including changes in debt itself, in the cash flow that is discounted. Although perhaps somewhat counterintuitive, raising debt financing increases the cash flow available for payments of dividends and share buy-backs and therefore needs to be included in the equity free cash flow. Failure to do this generally results in an understated value, considering the increase in debt that is likely to accompany business growth.

A further common mistake is to use a cost of capital that is inconsistent with assumptions about cash flow and leverage. For example, if market leverage (leverage based on the fair values of debt and equity financing) is not forecast to be constant, you need to calculate a different cost of capital for each year (unless the adjusted present value approach is applied).

In the interactive model below, we demonstrate how the three approaches to DCF work, and how to consistently deal with financial leverage and the value of the debt interest tax shield. Try different scenarios by changing the blue model input figures and observe how all three approaches always produce the same value.  

The downloadable version of the model contains further explanations and additional workings, including the underlying cost of capital calculations and valuation of the debt interest tax shield.

Interactive model: Comparison of alternative DCF approaches

— iPhone and iPad users: This model formats best if viewed in Google Chrome —


To see the full workings for this model, and for additional explanation about the calculations, please use the downloadable version.


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Illustrating the equivalence of different DCF approaches is by no means unique. However, we think our version adds different dimensions not seen in other models, including:

  • Dynamic level of debt: The model allows for specified debt cash flows in the explicit forecast period, which permit different financing scenarios to be modelled, such as increased leverage following an LBO.
  • Comprehensive valuation of the debt interest tax shield: The model includes a valuation of the debt interest tax shield that allows for changes in the level of debt, and which considers the risk associated with growth in debt linked to business growth.
  • Allowance for personal tax effects: The model includes an explicit input for differential personal tax rates for debt and equity returns (Tp’). If this value is positive and, consequently, there is a personal tax advantage for equity, a different ‘post-tax’ risk-free rate and equity risk premium is applied to cost of equity calculations. This input also affects the valuation of the debt interest tax shield and the leverage adjustments for beta. 

Enterprise versus equity free cash flow

The starting point for all DCF valuations is a forecast of free cash flow (FCF) – the cash flow that is available for distribution to capital providers after deducting any reinvestment in the business. However, there is no single definition of FCF – how it is defined depends on which capital providers we focus on. Essentially there are two approaches:

Enterprise free cash flow

Also called free cash flow to the firm (FCFF), enterprise FCF is the cash generated by operating activities, after deducting any reinvestment in operating assets. It equals the net cash distribution to all providers of capital. Enterprise FCF excludes cash flows related to financing if that financing is part of your definition of enterprise value. Therefore, there is no deduction for interest expense or adjustment for new, or repayments of, debt finance.

Ensure enterprise FCF is consistent with your enterprise to equity bridge 

It is important that enterprise free cash flow is consistent with your definition of enterprise value. If EV excludes certain investments or non-core assets, then cash flow arising from those assets must not form part of enterprise cash flow used in a DCF model. Similarly, if a liability such as a pension obligation is regarded as ‘debt-like’, and therefore part of EV, the payments to the pension fund to cover interest accretion and deficit repayments are not deducted in enterprise FCF. We discussed the treatment of pension liabilities in DCF analysis and provided an interactive model to illustrate the alternative calculations, in our article ‘DCF and pensions: Enterprise or equity cash flow?’.

Assets and liabilities (including net debt), whose flows are excluded from enterprise FCF, are instead included in the enterprise to equity bridge; this is used to convert the DCF derived target enterprise value to the value attributable to equity investors. We explain more in our article ‘Enterprise to equity bridge – More fair value required’.

Long-term reinvestment rate should be compatible with long-term growth

One of the key considerations when deriving free cash flow for DCF valuations is to ensure that the reinvestment in the business is consistent with the growth assumptions. It is easy to include over-optimistic assumptions where limited reinvestment is combined with high growth, with a resulting very high implied return on capital. This is something we addressed in our article ‘DCF terminal values: Returns, growth and intangibles’. In the model above we use one of the alternative terminal value techniques described in that article.  

Equity free cash flow

An equity free cash flow DCF approach is a direct valuation of equity based on the cash flow available for those equity investors. No separate enterprise to equity bridge is required.1Although there may need to be a total equity to common shareholder equity bridge if there are other forms of equity capital outstanding, such as employee stock options. Equity FCF is generally derived from enterprise FCF by adjusting for the cash flows attributable to debtholders and cash flows attributable to any other assets and liabilities that are excluded from the enterprise value. In the model above the net debt cash outflow is equal to the interest payable plus (minus) any repayment of (increase in) debt finance. 

Remember that the tax amount included in equity free cash flow must take into account the tax effect of debt interest payments, which is instead included in cost of capital in an enterprise FCF valuation.

Equity FCF must include the forecast change in debt as well as (post-tax) interest

It is very important in an equity free cash flow DCF valuation to include the forecast change in net debt in the cash flow itself. While it is possible to make an explicit forecast of constant debt, and therefore a change in debt of zero, this will almost certainly result in a change in leverage and the need to use a different cost of equity each period. While this can be accommodated in an explicit forecast period (as demonstrated by our model), in the terminal period there will not be a steady-state condition and the terminal value will almost certainly be incorrect.

In the equity FCF from which the terminal value is derived, ensure that the change in debt is set at the opening debt for that period multiplied by the assumed long-term growth rate. This ensures constant leverage and therefore a constant cost of equity in the terminal period.

Financial leverage in DCF valuation

The three main approaches to DCF that we demonstrate in the model each deal with the effects of financial leverage differently. 

In an equity free cash flow DCF, the debt interest cost and related corporate tax saving is included in the cash flow itself. In the methods based on enterprise FCF, the absolute amount of debt (at market value, not book value) is instead deducted from the implied DCF value in an enterprise to equity bridge. Each approach is valid, but you must ensure the cost of capital is consistent.

Only in an APV valuation is the discount rate unaffected by changes in leverage

The advantage of an enterprise FCF Adjusted Present Value (APV) approach is that the discount rate is always unaffected by changes in capital structure. Instead, any effect of forecast changes in debt is reflected in the separate calculation of the value of the debt interest tax shield. In both the enterprise FCF WACC approach and DCF based on equity FCF, the cost of capital is impacted by financial leverage. This is particularly the case for the equity FCF method where the discount rate is the cost of equity. For a WACC based valuation the potential for variations in the discount rate is smaller, but is only zero if there is no debt interest tax shield.

This can all be observed in the model above. Try changing some of the inputs, particularly those for a change in debt, to observe the results. The scenario we have included when you first load the model is for a significant new investment and additional debt finance in year 1. This is to highlight how the resulting change in leverage affects the three valuation approaches differently, albeit with the same ultimate equity value.

Leverage effect on beta

In any DCF valuation it is important that the discount rate (the cost of capital) is consistent with the approach used, and the financial leverage in each period. If leverage in market value terms (debt compared with market capitalisation) is forecast to remain constant, then in each of our three approaches there is no change in cost of capital or discount rate each period. Of course, the discount rate could change for other reasons such as an expected change in underlying business risk, such as a forecast reduction as a business matures.

When using CAPM to determine discount rates, the key calculation is adjusting equity beta for changes in leverage. In the model above we use following relationship:

{ ~~\sf Beta_{enterprise}~ = ~ Beta_{equity} ~x~ \dfrac{E}{E+D-TSp} + ~ Beta_{debt} ~x~ \dfrac{D-TSp}{E+D-TSp} ~~}
EFair value of equity
DFair value of debt
TSpValue of the debt interest tax shield arising from current debt and forecast changes in debt due to a change in debt policy

The basis for this formula is explained in our previous article ’Equity beta, asset beta and financial leverage’

Debt interest tax shield

The debt interest tax shield is an explicit component of the Adjusted Present Value (APV) approach. In APV, the business is initially valued assuming the it is all equity financed, with the discount rate based on the underlying enterprise or asset beta, and no recognition of the cost of debt or resulting tax savings. The absolute value of the debt interest tax shield is the present value of these tax savings, and this is separately added to the present value of enterprise cash flows.

Valuing the tax shield is the subject of some disagreement, particularly regarding the appropriate discount rate. We discuss this in our article ‘Valuing the debt interest tax shield’. Our conclusion in that article is reflected in the calculation shown in the model above. Essentially, we discount debt interest tax savings at the cost of debt, except any incremental tax shield due to business growth, which is valued at a higher risk adjusted rate. 

The debt tax shield is also implicit in both the WACC and equity free cash flow models. In both approaches the adjustments to equity beta for leverage should consider the tax shield. Additionally, for the WACC approach, the cost of debt included in WACC is the post-tax rate. While the three approaches all deal with the tax shield differently, ultimately each incorporates this contribution to value into the final result, as illustrated by identical valuations in the model.

An unusual feature of our model is that we have included potential personal tax effects in our calculation of the value of the debt interest tax shield. If the input ‘Relative personal tax advantage of equity’ (Tp’) is positive, the net tax advantage of debt is reduced. Personal tax effects on investment values are difficult to estimate, which is why in practice this value is often assumed to be zero.

Personal tax differences also affect the risk-free rate and ERP inputs for CAPM

One of the implications of different taxation of debt and equity income (i.e. Tp’ > 0) is that a different risk-free rate and equity risk premium (ERP) is required in CAPM. In the above model notice how a positive value for Tp’ results in a lower risk-free rate and equity risk premium for the calculation of the cost of equity. This produces a higher valuation for the business and for the equity shareholders’ interest, even with the lower debt tax shield. 

For more about the value of the debt interest tax shield and the effects of personal taxation see our article ‘Valuing the debt interest tax shield’. You will also find additional explanations of the calculations related to the debt interest tax shield in the downloadable version of the model.

Importance of consistency

If cash flows associated with an asset or liability are excluded from enterprise FCF, then you must include the fair value of the investment or financing claim in the enterprise to equity bridge. In addition, the cost (or indeed income) related to this liability or asset must also be included in the WACC calculation. For example, if you decide that a component of working capital, such as extended trade credit obtained from suppliers, is financing (and you therefore deduct the absolute amount in the enterprise to equity bridge) you must ensure that WACC and free cash flow also reflect this item as financing.

Summary of DCF methods and their components

  Discounted enterprise cash flow
 Discounted equity cash flowWACC approachAPV approach
Cash flowsFree cash flow for equity investors. Remember to include forecast changes in debt and the cash flow for non-core assets.Enterprise free cash flow. Exclude financing and non-core asset flows. Ensure tax only reflects operating activities. Same as for WACC.
Discount rateCost of equity.Weighted average cost of capital.The cost of equity (or WACC) assuming all equity financing. Discount rate must exclude any advantage arising from the tax deductibility of debt finance.
Changes to discount rate each periodIf modelling for equity and debt cash flows produces a change in financial leverage (market value of debt compared with equity) each period, then equity beta and the cost of equity must be adjusted.A change in leverage could materially affect WACC and necessitate additional modelling. However, in practice, a constant WACC is often acceptable.No change in discount rate even if leverage were to change. However, forecast changes in debt may affect the value of the debt interest tax shield.
Terminal valueEnsure both the reinvestment rate and new debt finance assumptions are consistent with the long-term growth assumption.Ensure the reinvestment rate is consistent with the long-term growth assumption.Same as for WACC.
Debt financeInclude all forecast debt flows in equity free cash flow.Deduct net debt and other debt equivalents, such as pension liabilities, in the enterprise to equity bridge.Same as for WACC.
Non-operating investments and non-core assetsInclude forecast non-core asset flows (potentially including purchases and sales) in equity free cash flow.Include the estimated fair value of investments and non-core assets as an addition to the DCF value in the enterprise to equity bridge. WACC may need to be adjusted if non-core asset risk differs from operating asset risk.Same as for WACC.
Debt tax shieldNot separately included because it is implicit in the cash flows and discount rate applied. Only directly relevant if beta leverage and deleverage adjustments are used.Not separately included because debt interest tax savings are part of the cost of debt and therefore WACC.The present value of debt interest tax savings is a separate component of value that is added to the PV of enterprise free cash flow. Remember to discount at the unleveraged cost of equity and not WACC. 
Equity personal tax advantageAdjust the cost of equity to reflect a post-tax risk-free rate and equity risk premium.Adjust the cost of equity to reflect a post-tax risk-free rate and equity risk premium.Adjust the cost of equity to reflect a post-tax risk-free rate and equity risk premium.
Include in the absolute value of the tax shield by using an adjusted tax rate (T*).

So which DCF method should you use in practice?

Overall, we think that in most valuation situations it is best for investors to apply the WACC  approach – enterprise FCF discounted at WACC – with the application of an enterprise to equity bridge to derive a target equity value. This is not because it gives a more accurate answer. As we demonstrate in the model above, each method should always give the same result when done correctly. The reason for our preference is that we feel this approach is easier to apply, requires less forecasting and investors are less likely to make errors.

Forecasts of debt cash flow

All three DCF methods we explain require forecasts of enterprise cash flows but, additionally, in a discounted equity cash flow approach, a forecast of debt flows is also required. One of the common errors we see in DCF models is to only allow for debt interest and not changes in debt. If this is how you forecast, a different cost of equity will be required each period. Furthermore, this makes it very difficult to produce a valid terminal value.

Dealing with non-operating investments

Non-operating assets and investments are best included as separate components of a valuation. This means excluding cash flows attributable to these assets from free cash flow, which is much easier in an enterprise free cash flow approach.

Changes in leverage

Only the APV approach to an enterprise free cash flow DCF has a discount rate that is unaffected by leverage changes. Strictly, the WACC approach would require a varying WACC if market leverage is not constant. However, it is rare for WACC to vary significantly, and we think in practice, it is generally acceptable to use a single WACC based on either the current, or more likely target capital structure. However, if you use a target leverage, make sure that your equity beta correctly reflects this level of financial risk. 

Insights for investors

  • All DCF approaches should give the same result if they are based on consistent underlying assumptions. If not, there is something wrong with your model.
  • Be careful to ensure model consistency. Your definition of free cash flow must match your approach to the enterprise to equity bridge and cost of capital.
  • Discounted equity cash flow is likely to require a dynamic cost of equity, unless you include in your free cash flow measure debt flows that produce constant market leverage.
  • Discounted enterprise cash flow makes it easier to allow for investments and non-core assets. Include these in the enterprise to equity bridge and not as a component of free cash flow.
  • Only the adjusted present value approach has a discount rate that is unaffected by changes in financial leverage. However, changes in debt still impact the valuation of the debt interest tax shield.
  • When using DCF valuations it is generally best to adopt a discounted enterprise value approach using WACC as a discount rate. This is less likely to result in inconsistencies but still be careful to ensure you don’t end up with spurious valuations.

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