Chapter 3- Discounted Cash Flow Analysis

Question 1

Why does WACC decrease prior to increasing as debt is introduced into the capital structure?

Answer 1

Due to the tax implications and deductibility of having debt in your capital structure, WACC decreases until reaching the optimal capital structure.

Following this, WACC increases due to the increase in required return demanded for the excess risk of financial failure as debt levels increase.

Question 2

When calculating WACC why must you unlever Beta when creating a comparable average?

Answer 2

We must unlever beta in order to account for differences in capital structure that may arise across peers.

Question 3

What is the next step after finding the average unlevered Beta for a peer group?

Answer 3

The beta must then be relevered at the target D/E ratio.

Question 4

How do you estimate the cost of debt for a company with publicly traded debt?

Answer 4

Most often if the company has outstanding debt, a banker may use this cost as a general estimate; however a caveat is that the company must be at its target capital structure.

Question 5

What May a banker sensitize when creating a DCF model.

Answer 5

-WACC
-Terminal Value
-Perpetual Growth Rate
-Value Drivers

Question 6

What circular reference may occur when projecting an implied share price with a DCF?

Answer 6

The implied share price will have a circularity with fully diluted shares outstanding, due to the fact that share price determines which contracts are exercisable.

Question 7

How does one project for mid-year cash flow?

Answer 7

By subtracting n by 0.5. This will often result in a larger valuation.

Question 8

What are the steps of a DCF?

Answer 8

1.) Study the target and determine key financial drivers.
2.) Project FCF
3.) Calculate WACC
4.) Determine terminal value
5.) Calculate PV and valuation.

Question 9

What is the formula for FCF?

Answer 9

NOPAT-Change in NWC-Capex+Dep and Amort

Question 10

What is the formula for NOPAT?

Answer 10

EBIT(1-t)

Question 11

Why is free cash flow to the firm preferred over free cash flow to equity holders?

Answer 11

FCFF is independent of capital structure which skews results as each company has a different capital structure.

Question 12

How are sales typically projected?

Answer 12

In the first 2-3 years, equity research estimates suffice if available, or not historical data growth rates and profit margins must be looked at.

Question 13

How is depreciation forecasted?

Answer 13

As a % of sales or a % of capital expenditure.

In some cases the creation of a PPE schedule may be appropriate, however, most often it does not affect the projection significantly.