Unlevered free cash flow

Unlevered free cash flow (UFCF) is the cash a business throws off from its operations before it pays a cent of interest. That's the whole idea behind the word "unlevered." Strip out the effect of debt, and what's left is the cash that belongs to everyone who funded the company: lenders and shareholders alike.

That one property is why it sits at the center of a DCF. It's the number you project, discount, and sum to get enterprise value. Get the build wrong and the rest of the model is pointing at the wrong answer.

The formula

$\text{UFCF} = \text{EBIT}\times(1-t) + \text{D\&A} - \Delta\text{NWC} - \text{CapEx}$

Read it left to right and each piece has a reason to be there.

Start with EBIT, then tax it

EBIT is operating profit before interest. You start here on purpose. Net income sits below interest expense, so it already reflects how the company is financed. EBIT doesn't. It's the profit the operations produce regardless of the capital structure, which is exactly what you want when the goal is cash for all investors.

Then you tax it: $\text{EBIT}\times(1-t)$. This is sometimes called NOPAT (net operating profit after tax). Notice you're taxing EBIT directly, not taxing EBIT-minus-interest the way the real income statement does. You're deliberately ignoring the interest tax shield here, because the benefit of debt gets captured later in the discount rate, not in the cash flow. More on that below.

Add back D&A

Depreciation and amortization got subtracted to compute EBIT, but it's a non-cash charge. No cash left the building this year. So you add it back. The company recorded the expense on paper; the actual cash went out the door years ago when the asset was bought.

Subtract the change in net working capital

Net working capital is the cash tied up in running the business day to day: receivables and inventory, less payables. When a growing company sells more, it usually has to carry more inventory and wait longer to collect from customers. That's cash locked up, so an increase in working capital is a use of cash and you subtract it.

The $\Delta$ (delta) matters. It's the change year over year, not the level. If NWC goes up by 20, that's 20 of cash consumed.

Subtract CapEx

Capital expenditures are the real cash spent on property, plant, and equipment to keep the business running and growing. It's a cash outflow that never touched EBIT (only its depreciation did, years later), so you subtract the full amount here.