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
