3.11) Factors That Affect a DCF Analysis Flashcards
- Which assumptions make the biggest impact on a DCF?
The Discount Rate and Terminal Value make the biggest impact on the DCF. That’s because the Discount Rate affects the PV of everything and because the PV of the Terminal Value often represents 50%+ of the company’s Implied Value. The assumptions for revenue growth and operating margins also make a significant impact, but less than the ones above. Other items, such as CapEx, Working Capital, and non-cash adjustments, make a smaller impact for most companies.
- Should the Cost of Equity and WACC be higher for a $5 billion or $500 million Equity Value company?
Assuming that both companies have the same capital structure percentages, the Cost of Equity and WACC should be higher for the $500 million company. All else being equal, smaller companies tend to offer higher potential returns and higher risk than larger companies, which explains why the Cost of Equity will be higher. Since smaller companies have a higher chance of defaulting on their Debt, their Cost of Debt (and Preferred) also tends to be higher. And since all these Costs tend to be higher for smaller companies, WACC should be higher as well, assuming the same capital structure percentages.
- Would increasing the revenue growth from 9% to 10% or increasing the Discount Rate from 9% to 10% make a bigger impact on a DCF?
The Discount Rate increase will make a bigger impact. Increasing the revenue growth from 9% to 10% will barely affect the FCF and Terminal Value, but the Discount Rate will affect the Present Value of everything, and 9% vs. 10% is a significant difference.
- Would it make a bigger impact to increase revenue growth from 9% to 20%, or to increase the Discount Rate from 9% to 10%?
It’s harder to tell here. Doubling a company’s revenue growth could make a bigger impact than changing the Discount Rate by 1%, but when the changes are this different, you’d have to run the numbers to tell. These operational changes make a bigger impact in longer projection periods than in shorter ones, so you would see more of a difference in a 10-year DCF than a 5-year one.
- Two companies produce identical total Free Cash Flows over 10 years, but Company A generates 90% of its Free Cash Flow in the first year and 10% over the remaining 9 years. Company B generates the same amount of Free Cash Flow every year. Which company will have the higher Implied Value in a DCF?
This is a trick question because it depends on what you count toward the Implied Value. If it’s just this series of cash flows, Company A will have the higher Implied Value because of the time value of money: the cash flows arrive earlier, so they’re worth more. However, Company B will almost certainly have a much higher Terminal Value because it has a much higher FCF in Year 10. So, if the Implied Value = PV of FCFs + PV of Terminal Value, Company B will have the higher Implied Value.
- How does the tax rate affect the Cost of Equity, Cost of Debt, WACC, and the Implied Value from a DCF?
The tax rate affects the Cost of Equity, Cost of Debt, and WACC only if the company has Debt. If the company does not have Debt, or its targeted/optimal capital structure does not include Debt, the tax rate doesn’t matter because there’s no tax benefit from Debt in that case. If the company has some Debt, a higher tax rate will reduce the Cost of Equity, Cost of Debt, and WACC. It’s easy to see why it reduces the Cost of Debt: since you multiply by (1 – Tax Rate), a higher tax rate reduces the after-tax cost. But it also reduces the Cost of Equity for the same reason: with a greater tax benefit, Debt is less risky even to Equity investors. If both of these Costs are lower, WACC will also be lower. However, the Implied Value from a DCF will also be lower because the higher tax rate reduces the FCF and the Terminal Value, and these changes outweigh a lower WACC. The opposite happens with a lower tax rate: the Cost of Equity, Cost of Debt, and WACC are all higher, and the Implied Value is also higher.
