What is the effect of interest expense on Free Cash Flow in a levered DCF analysis?

In a levered Discounted Cash Flow (DCF) analysis, interest expense directly impacts Free Cash Flow (FCF). FCF is calculated after taking into account all operating expenses, capital expenditures, and it is measured on a net income basis, which includes the effects of interest expenses.

When a company incurs interest expense, it reduces the net income, which in turn lowers the Free Cash Flow. This is because Free Cash Flow is derived from net income adjusted for non-cash expenses, changes in working capital, and capital expenditures. Since interest expenses are deducted from revenues to arrive at net income, they effectively diminish the amount of cash flow that is available to equity holders after all outgoing payments have been accounted for.

This means that the company's cash flow generation capability is reduced when interest expenses are factored in, confirming that Free Cash Flow decreases as a result of incurred interest expenses. Understanding this relationship is crucial, particularly in a levered DCF analysis, where the company's debt levels and associated interest obligations are fundamental to the valuation process.