DCF Flashcards
How will adding debt affect WACC?
Push down WACC b/c Cost of Debt is almost always lower than cost of equity - interest rates on debt are lower and interest is tax deductible
Use a DCF to value a Gold Mine
You would value the cash flows to the Gold Mine and the Terminal Value would be 0
Assuming no capex is spent, how would you value a windfarm whose entire assets have a useful life of 20 years with 0 residual value?
You would value the cash flows incorporating a 5% depreciation per year for 20 years. At the end of the 20th year, the value of the assets would be 0 and no capex would be spent so the Terminal Value would be 0
Cost of Equity Definition
The return that a firm theoretically pays to its equity investors to compensate for the risk they undertake by investing their capital
Cost of Debt Definition
The rate that a company pays on its borrowed debt
WACC Definition
Rate that a company is expected to pay on average to all its security holders to finance its assets
Why would Enterprise Value go up if WACC increases?
If we have negative CFs, Enterprise Value would go up if WACC increases
How would you compare a DCF from 2 years ago to today? What has changed?
Enterprise Value would be decreasing because cost of debt increases which increases your WACC. You’re discounting your cash flows at a higher rate which reduces the PV of the CFs. This means that your EV will be lower.
How do you calculate changes in operating working capital in a DCF?
(Current Assets - Cash) - (Current Liabilities - Debt)
How would you interpret the discount rate in a DCF? What is it measuring?
The return investors are expecting to earn, at a minimum when they invest in this company.
Would you expect larger or smaller companies to have a larger discount rate?
Smaller companies tend to have a higher discount rate because because investors expect that they will grow more and deliver higher growth, profits and returns in the future.
They are also “riskier” than larger companies
What does the equity risk premium measure
The extra yield you could earn by investing in an index that tracks the stock market in your country of choosing
How would I interpret the Beta of a company of 2?
The company is twice as risky as the market. If the market goes up by 10%, the stock will increase by 10%. If the market goes down by 10%, the stock will go down by 10%
What does Beta measure?
Beta helps determine what a company’s riskiness should be rather than what it currently is.
What are two types of risk associated with a company?
Inherent Business Risk -
Debt Risk - defaulting on debt or not being able to service that debt
*Risk of a company comes from its D/E ratio
Can higher interest payments on debt reduce risk?
Interest paid on debt is tax deductible so it can help reduce the risk from taking on that debt slightly, since we save on taxes
How can equity cost a firm?
2 Ways:
1) If the company issues dividends to common shareholders, that is an actual cash expense
2) By issuing equity to other parties, the company is giving up future stock price appreciation to someone rather than keeping it for itself
When calculating Beta, do you usually use the company’s future or target capital structure?
You usually use the company’s future target capital structure but a lot of times we don’t have access to that information so we would use the current capital structure.
Walk me through how you would use the multiples method to determine a terminal value of a company.
You would assume that the company is sold for a far in future EV/EBITDA multiple (use a range of EBITDA multiples in a sensitivity analysis) and apply that to the year 5 EBITDA value.
You would sensitize EV/EBITDA multiple against discount rates to come up with a range of values
Walk me through how you would use the Gordon Growth Method or perpetual growth method to calculate terminal value.
Assume that a company operates indefinitely and sum up its future cash flows.
The PV of the future CFs each year keeps shrinking because the discount rate is higher than the growth rate.
Which method for valuing terminal growth is the best method to use?
There is no “best” method to use. Usually you use both in a DCF and compare the results.
While the multiples method may be easier to use, in which cases would we prefer to use the Gordon Growth Method?
We would use the Gordon Growth Method in an industry that is cyclical or multiples are hard to predict.
If the multiples are easier to estimate, it may be better to use the multiples method.
Will the cost of equity be higher for a $500m or $5b company?
Cost of equity will be greater for smaller company ($500m) because all else equal the company is riskier and therefore investors will demand a higher return.
The same principal can be applied to cost of debt (it will be higher for smaller companies)
Will a 1% change in revenue or a 1% change in the discount rate have a greater impact on the DCF?
1% change in discount rate
Will a 10% change in revenue or a 1% change in discount rate have a greater impact on the DCF?
Hedge answer by saying it varies greatly by company and assumptions you’ve made. it could go either way.
How does increasing debt affect Cost of Equity?
Adding debt raises the Cost of Equity because because it makes the company riskier for all investors. Beta will be higher b/c (D/E) will be larger.
How does increasing equity affect Cost of Equity?
Adding equity lowers the Cost of Equity because the % of debt in the capital structure decreases. Beta will be lower b/c (D/E) will be lower.
Will smaller or larger companies typically have a higher cost of equity?
Smaller, Emerging Markets companies typically have a higher cost of equity because their expected returns are larger
How does additional debt impact your WACC
Additional Debt reduces WACC because debt it less expensive than equity. Yes, the levered Beta will go up but the additional debt in the WACC formula more than makes up for the increase.
How do higher IRs impact WACC?
They increase WACC because they they increase the cost of debt
What is the point of Free Cash Flow?
Basic idea is that you are replicating the CF Statement but only including recurring, predictable items
Why might we want to forecast cash flows 10+ years into the future?
If the company is in a cyclical industry it may be important to show the cycle from high to low
What if you calculate share price of $10 in DCF but company is trading at $5, what does that mean?
Nothing! You need to look at a range of outputs from a DCF
What is an alternative to a DCF?
Dividend Discount Model
How is a Dividend Discount Model (DDM) different to a DCF?
Setup is similar to a DCF
Do not calculate FCF, instead you stop at Net Income and assume that Dividends Issued are a % of Net Income and then you discount those dividends back to PV using cost of equity
Add those up and add them to the PV of the TV which you may base on P/E multiples
*This gets you to equity value rather than enterprise value since you’re using metrics that include interest income and expense
What is the DDM?
It is an alternative to a DCF and predicts the price of a companies stock based on the sum of the PV of its dividends
What discount rate do you use in the DDM and why?
Use Cost of Equity because you’re using metrics that include interest income and expense
Why do you add back non-cash charges when calculating FCF?
You want to reflect the fact that they save the company on taxes, but the company doesn’t actually pay the expense in cash
Can we use EBITDA - Change in Operating Assets and Liabilities - Capex to approximate Unlevered FCF?
No, because this excludes taxes. Taxes are significant and shouldn’t be overlooked
What is Free Cash Flow?
Cash the company generates after accounting for cash outflows to support operations and maintain its capital assets
What is the point of the “Changes in Operating Assets and Liabilities Section?
It means that is assets are increasing more than liabilities, the company is spending cash and therefore reducing cash flow, whereas if Liabilities are increasing by more than assets, the company is increasing cash flow
We want to look at operationally-linked balance sheet items
What happens in a DCF if FCF is negative? What if EBIT is negative?
Nothing happens and you can still run the analysis
In a DCF, if you go from Levered FCF to Equity Value and Unlevered FCF to Equity Value, will the equity values be the same?
No, difficult to pick equivalent assumptions in both cases because the terms of the debt impact the FCF in an unlevered FCF
How are dividend yields factored into the cost of equity formula?
Dividend yields are already factored into beta
When would you use the alternative cost of equity formula?
(Dividends per Share / Share Price) + Growth Rate of Dividends
Used when the company is guaranteed to issue dividends (utilities companies) or when information on Beta is unreliable
Why do you have to un-lever and re-lever beta?
Each company’s capital structure is different and we want to look at how risky the company is regardless of what % debt or equity it has
Taking into account the company’s capital structure to identify its inherent business risk
How should you account for preferred stock when calculating Beta?
It counts towards equity because preferred dividends are not tax deductible, unlike interest paid on debt
Can Beta ever be negative?
Yes, if Beta moves in the opposite direction of the stock market as a whole
This is very rare
Counter cyclical Betas are typically from 0.5-0.7
What is the company paying for in cost of equity?
1) It may issue dividends which is a cash expense
2) It gives up stock appreciation rights to other investors - losing some of the upside
If a firm is losing money, do you still multiply cost of debt by (1-T) in the WACC formula?
Yes, because there is a potential for it to make money in the future.
How do you determine a firm’s optimal capital structure? What does it mean?
Optimal capital structure is one that minimizes WACC. There is no solution. Ideally it should be 100% debt but this can’t happen b/c you need equity
During an economic downturn, what would happen to WACC?
Companies became less valuable because markets discounted their future CFs at a higher rate. So WACC would almost certainly increase
Cost of Equity: Would Increase
Risk Free Rate would decrease because governments worldwide would drop IR to encourage spending
Equity risk premium would also increase by a good amount as investors demand higher returns before investing in stocks
Beta would increase due to volatility
Cost of Debt:
Cost of debt and cost of preferred stock would increase as it would become more difficult to borrow money
What is the flaw in basing Terminal Multiple on what public comps are trading at?
The median multiples may change drastically in the next 5-10 years so they may no longer be accurate by the end of the period you’re looking at. This is why you would want to run a sensitivity analysis
How do you know a DCF is too dependent on future assumptions?
> 50% of the value is attributed to the PV of its TV terminal value
Two companies receive same FCF total amount but one receives 90% in first year and 10% following years. Other company receives equal amount each year. Which has higher net present value?
The first company because money today is worth more than money in the future
Is WACC higher for $500m or $500b company?
Depends on capital structure but will be greater for $500m if same capital structure.
What is the relationship between debt and cost of equity?
More Debt = More Risk –> Higher Levered B and increased cost of equity
Less Debt = Less Risk –> Lower Levered B and lower cost of equity
*all else equal
Cost of Equity = Rf + B(Rm - Rf)
Two companies are exactly the same, but one has debt and the other doesn’t. Which will have the higher WACC?
The one without debt will generally have a higher WACC because debt is “less expensive” than equity
Then is the company that doesn’t take on debt at a disadvantage to the one that does?
No it’s not at a disadvantage, it won’t be valued as highly because of the way WACC formula works
If FCF in the projection period of a DCF increase by 10% each year, how much will the company’s EV increase by?
Less than 10% because you are discounting the cash flows to present value
In addition, you need to include terminal value and the present value of that hasn’t increased by 10%
What are the most common sensitivity analysis used in a DCF
Revenue Growth v Terminal Multiple
EBITDA Margin v Terminal Multiple
Terminal Multiple v Discount Rate
Terminal Growth Rate v Discount Rate
If a company has a high debt balance and is paying off a significant portion of its debt principle each year. How does that impact a DCF?
Doesn’t impact an unlevered DCF because we are ignoring interest expense and principle payments
In a Levered DCF, you would factor it in by reducing interest expense each year as the debt goes down and by reducing FCF by the mandatory repayments each year
In a Levered DCF, are you better off paying debt quickly or repaying the bare minimum required?
Always better to pay the bare minimum. Company is always better off valuation wise to wait as long as possible to pay off the debt (think of time value of money concept)
What is the mid-year convention in a DCF?
The mid year convention discounts each CF by half a year - Year 1 is 0.5, Year 2 is 1.5…
Concept here is that we don’t know exactly when the CFs come in so use the mid-year convention to represent that the CFs come in evenly throughout each year
If you were to utilize the midyear convention, would this yield higher or lower valuations?
Using the midyear convention would yield higher valuations because the discount periods of the CFs would be lower
What is the point of a “stub period” in a DCF? Can you give an example?
The stub period is the period between the valuation date/transaction date and the beginning of the financial year. It is used when valuing a company before or after the end its fiscal year and there are 1 or more quarters in between the current date and the end of the fiscal year.
You need to account for the periods the company generates FCF for the 3 months between now (Sept 30th) and Jan 1st (beginning of fiscal year)
3 month stub period would be using 0.25 as a discount factor for first 3 months and then one year later it would be 1.25
What discount factor would you use for the mid year convention if you had stub periods?
The rule is that you divide the stub discount period by 2 (for the first 3 months) and then subtract 0.5 from the “normal” discount period for the future years
How does a DCF for a private company work?
Mechanics are the same but challenging to calculate Cost of Equity and WACC because can’t find market value of equity or Beta so may estimate WACC based on public comps
How do you factor in one-time events such as raising debt, completing acquisitions, and so on in a DCF?
Normally you ignore one-off events in a DCF because you’re looking for CF on a recurring and predictable basis
Why would you not use a DCF for a bank or other financial institution?
Banks use debt differently than other companies - they use it to create their own products - loans - instead
Interest is also a part of a bank’s business model and changes in Operating Assets and Operating Liabilities can be much larger than a bank’s Net Income
Walk me through a Dividend Discount Model
1) Project Company’s earnings down to EPS
2) Assume a Dividend Payout Ratio (what % of EPS gets paid out to shareholders in the form of Dividends)
3) Use this to calculate the dividends over the next 5-10 years
4) Do a check to make sure that the firm still meets its required Tier 1 Capital Ratio and other capital ratios
5) Discount the dividends each year to their present value based on Cost of Equity
6) Calculate Terminal Value based on P/BV and Book Value in the final year, and then discount this to its present value based on Cost of Equity
7) Sum the PV of TV and PV of Dividends to calculate company’s Net Present Value per Share
Would a DCF work well for an Oil and Gas company?
No, because CapEx needs are enormous and would push down FCF to very low levels. In addition, commodity prices are cyclical and both revenue and FCF are hard to project.
If you’re valuing an emerging market company, how would a DCF change?
Use a much higher discount rate and may not link it to WACC or Cost of Equity b/c there may not even be a good set of public comps in the country.
May also add in a premium for political risk and uncertainty
How do Pension Obligations and Pension Expenses factor into a DCF?
Unlevered DCF - count unfunded pension obligations as debt and exclude pension related expenses from unfunded obligations on the income statement and cash flow statement
Levered DCF - leave in the expenses because they are a form of interest expense
Can you explain how to create multi-stage DCF, and why it might be useful?
If the company grows at much different growth rates, has different profit margins, or has different capital structure in different periods.
Separate into multiple stages and make assumptions about FCF and discount rate in each one
