BIWS DCF Questions CSV

Question 1

Walk me through a DCF…

Answer 1

What are the major steps in a DCF analysis?

“The value of a company is equal to the present value of its projected future Free Cash Flow”

Step I: Study the Target and Determine its Key Performance Divers

Step II: Project Free Cash Flow During the Projection Period

1) Normalize and analyze historical financials as a basis for projection
2) Project Key Drivers: Income Statement through EBIT, marginal tax rate, D&A, CapEx and Working Capital Items
3) Calculate Unlevered Free Cash Flow for each year in the projection period

Step III: Calculate the Weighted Average Cost of Capital (WACC)

1) Determine Capital Structure
2) Determine Cost of Debt based on outstanding debt of target or similar companies
3) Calculate Cost of Equity using the CAPM

Step IV: Determine Terminal Value using either the EMM or the PGM

Step V: Discount projected Unlevered Free Cash Flows and Terminal Value to present using the WACC to get Enterprise Value. We can then calculate Equity Value and Diluted Shares Outstanding to get a share price for the company that we are valuing.

P&R pg. 110, BIWS Guide pg. 119 (Q2)

Question 2

Why do we use a 5 to 10 year projection period?

Answer 2

We want to project the business to the point where it is at a steady state and not a cyclical high or low, which usually takes at least 5 years. However, it becomes hard to project the cash flows to a reasonable degree of accuracy outside of 10 years

BIWS Guide pg. 120 (Q4)

Question 3

Why do we un-lever and re-lever Beta?

Answer 3

A stock’s riskiness relative to the market will be impacted by its capital structure, as companies with a high level of debt are typically viewed as being more risky. Therefore, we want to determine what the Beta for a company is independent of its capital sturcture, so we unlever beta. We then want the beta for our company to reflect its true risk and to account for its capital structure, so we re-lever beta

BIWS Guide pg. 121 (Q9)

Question 4

Would you expect a manufacturign company or a technology company to have a higher Beta?

Answer 4

It depends on which company is riskier - on average technology companies tend to be more risky and should have a higher Beta

BIWS Guide pg. 121 (Q10)

Question 5

Do we use EMM or PGM more frequently to calcluate Terminal Value?

Answer 5

We use EMM more frequently because it is based on market data (the trading multiples of comparable companies) and not on an estimate

BIWS Guide pg. 122 (Q14)

Question 6

When might we use PGM instead of EMM?

Answer 6

If a company doesn’t have strong copmarables or if we believe the industry multiples are significantly out of line at present and will change through time (e.g. your industry is currently at a cyclical high or low)

BIWS Guide pg. 122 (Q14)

Question 7

How do you select the appropriate multiple to use when calculating Terminal Value?

Answer 7

We look at Comparable companies and generally choose the median of the set. Note that we almost always sensitze this assumption to see what our valuation would yield for a range of multiples

BIWS Guide pg. 123 (Q16)

Question 8

What’s the primary flaw with the EMM?

Answer 8

Multiples may be affected by 1) lack of pure-play comparables or 2) market distortions (e.g. cyclical highs or lows)

BIWS Guide pg. 123 (Q18)

Question 9

What the primary flaw with the PGM?

Answer 9

It relies on an assumption that we make

Question 10

In what range do we believe that the Terminal Value may be contributing too much to our valuation?

Answer 10

If Terminal Value accounts for 80-90% or our valuation, we may consider re-visiting our assumptions in most cases

BIWS Guide pg. 123 (Q19)

Question 11

Should Cost of Equity be higher for a $5B or a $500M market cap company?

Answer 11

It should be higher for the $500M company because, all else being equal, smaller companies are viewed as more risky

BIWS Guide pg. 124 (Q20)

Question 12

Should WACC be higher for a $5B or a $500M market cap company?

Answer 12

It depends on two factors:

1) The amount of debt in the capital structure - the company that is above or below it’s optimal capital structure will have a higher WACC. This could be either the bigger or the smaller company
2) The cost of equity - the smaller company should have a higher cost of equity (all else being equal)

BIWS Guide pg. 124 (Q21)

Question 13

What’s the relationship between debt and the Cost of Equity?

Answer 13

As a company issues more debt the possibility of financial distress increases, which should increase a company’s Beta and therefore increase the Cost of Equity (that’s why our “Cost of Equity” line rises in the “Optimal Capital Strcuture Diagram” as Debt/Total Capitalization increases)

BIWS Guide pg. 124 (Q22)

Question 14

Cost of Equity tells us what return an equity investor should expect from a given company - do we also need to consider dividends?

Answer 14

No! Dividends are factored into Beta because beta measure the market return and company return including both dividends and stock appreciation

BIWS Guide pg. 124 (Q23)

Question 15

What is an alternate formula for Cost of Equity? (besides CAPM) When might we use it?

Answer 15

Cost of Equity = Dividends per Share / Share Price + Growth Rate of Dividends

We might use this formula if we don’t have access to information on Beta (unilkley)
BIWS Guide pg. 124 (Q24)

Question 16

Why is debt less expensive than equity?

Answer 16

1) Interest on debt is tax-deductible
2) Debt is senior to equity in a company’s capital structure and is therefore less risky in the event of a bankruptcy/liquidation

BIWS Guide pg. 124 (Q25)

Question 17

Two companies are exactly the same, but one is debt-free and the other has debt in the capital strcuture - which one will have the higher WACC?

Answer 17

It depends - adding debt decreases the cost of capital up to a certain point since debt is cheaper than equity. However, once too much debt is added the cost of debt increases due to increased risk. Therefore, ther WACC follows a U-shaped curve and the answer depends on how much debt the company has outstanding

BIWS Guide pg. 125 (Q25)

Question 18

Which has a greater impact on a company’s DCF valuation - a 10% change in revenue or a 1% chang in the discount rate?

Answer 18

It depends - but generally a 10% difference in revenue will have more of an effect (remember that increased revenue during the projection period effects not only current year revenue but also our terminal value since it’s based on final year EBITDA/FCF!)

BIWS Guide pg. 125 (Q26)

Question 19

What has a greater impact on a company’s DCF valuation - a 1% change in revenue or a 1% change in the discount rate?

Answer 19

It could go either way, but generally I would expect the 1% increase in WACC to have more of an effect

BIWS Guide pg. 126 (Q27)

Question 20

What are common sensitivties in a DCF?

Answer 20

Generally we sensitize the key assumptions that drive our valuation, including: Terminal Multiple, Long-Term Growth Rate, Discount Rate

BIWS Guide pg. 126 (Q31)

Question 21

A company has a high debt oad and is paying off a significant portion of its principal each year. How do you account for this in a DCF?

Answer 21

These interest payments do not affect Unlevered FCF calculation and therefore don’t affect our Enterprise Value calcluation. When it comes time to calculate Equity Value, we would subtract the amount of debt from Enterprise Value to arrive at Equity Value.

BIWS Guide pg. 127 (Q32)

Question 22

Why do we use a mid-year discount in a DCF? What is our discount factor using a mid-year convention?

Answer 22

We use a mid-year discount because in real-life a company receives the cash flow evenly throughout the year. The discount factor for Year 1 is 0.5, or Year 2 is 1.5, and so on…

BIWS Guide pg. 128 (QA1)

Question 23

Explain how a stub adjustment works

Answer 23

Generally we need to a) account for the cash flow that we’ll receive during the remaineder of this year and b) make sure that we’re discounting future cash flow appropraitely relative to today, so we make a stub year adjustment…
Stub Year: Discount by (1+WACC)^(Stub-Year Fraction / 2)
Full Years: Dicount by (1+WACC)^(Year # - 0.5 + Stub-Year Fraction)

BIWS Guide pg. 128 (QA2) - match with what you did in the modelling guide!

Question 24

Does the PGM/EMM use mid-year discounting/stub year adjustment?

Answer 24

PGM does use mid-year discounting. EMM does not. Both require a stub year adjustment.

In both cases, we use/modify our discount factors from the final year of the model

BIWS Guide pg. 128 (QA3), P&R pg. 135, checked that we use stub-year in the WSP model in both cases!

Question 25

How do we calcluate the per-share value of a public company using a DCF?

Answer 25

First we calcluate Equity Value by taking Enterprise Value, subtracting Total Debt, Preferred Stock and Noncontrolling Interest, and adding back Cash and Equity in Affiliates.

Next, we calculate Diluted Shares Outstanding. We use the current share price and the TSM (Note: BIWS uses a circular reference instead of current share price, WSP uses current share price)

Finally, we divide the Equity Value by the Diluted Shares Outstanding

BIWS Guide pg. 129 (QA4)

Question 26

What is once case where you might use a Dividend Discount Model? Walk me through a Dividend Discount Model…

Answer 26

We would use a Dividend Discount model to calue a financial institution…

The mechanics are the same as a DCF, but 1) focus on dividends rather than Unlevered Free Cash Flows (so we project through EPS and assume a dividend payout ratio during our projection period), 2) calculate terminal value based on P/E and EPS in the final year and 3) discount our future dividends and terminal value using the Cost of Equity rather than the WACC

BIWS Guide pg. 129 (QA5)

Question 27

Let’s say that CapEx increases by $100 in Year 4, how does our Enterprise Value change?

Answer 27

Our Unlevered FCF falls by $100 in Year 4, so the Present Value of that FCF falls by $100 *1/(1+WACC)^(4-0.5+Stub-Year Fraction) assuming a mid-year discount. Enterprise Value falls by that amount

If Year 4 is our terminal year and we’re using the EMM, then Terminal Value is unchanged. If we’re using the PGM, then our terminal year Cash Flow will decrease and our terminal value will be reduced as well!

BIWS Guide pg. 130 (QA7)