DCF Flashcards
What if company can’t deliver project with return larger than WACC?
Future Cash Flows will be discounted with WACC, and thus achieve a lower valuation. Share price will go do down to align with the required rate of return
What are the pros and cons of a DCF?
Pros:
-Intrinsic value
-Takes into account synergies, management expectations and tax shield
Cons:
-Extremly sensitive to change in assumptions
-WACC only works if capital structure doesn’t change
Why do we use a 10y. T-Bond for risk free rate?
a) Riskless security
b) Use as long-dated an instrument as possible to match the expected life of the company
c) Lack of liquidity on issuance of 30y. treasury bonds, so 10y. is preferred
How do you find cost of debt?
Option 1: Use the Yield to Maturity implied by the trading price of a company that has publicly traded debt
Option 2: Estimate the credit rating based on its leverage ratios and operating statistics and use the current market yields for similarly rated companies in that sector
How do you find optimal capital structure?
If you look at impact of capital structure on WACC.
1) Start with Equity Only
2) As you add debt, you lower your WACC
3) Past certain threshold, cost of potential financial distress overrides the tax advantages of debt and both debt and equity holders ask for higher yield
How to calculate value of a firm using APV?
a) Discount FCFu with Re to derive Equity Value
b) Add Present value of tax shield from debt
c) Deduct Value cost of financial distress
What do cost of financial distress cover?
i) Direct bankruptcy costs (e.g. court fees)
ii) Indirect bankruptcy costs (e.g. additional costs of supply when company is near bankrupt, poor decisions making when bondholders and stakeholders are in conflict)
Differences between WACC and APV?
APV:
1) Is more academic
2) Doesn’t assume constant D/ D+E ratio
What is PEG ratio?
P/E divided by Growth rate of EPS
> 1 is poor
< 1 is good
< 0.5 is excellent
How do you increase stock price
1) Pay/ increase dividend
2) Increase transparency of financial statements
3) Acquire company paying less than its NPV
4) Any positive NPV projects
5) Signal cheap stock by doing buybacks
What are effects of buybacks?
In favour of share price increase:
1) EPS increases (investor anticipate it and share price appreciates)
2) Signaling effect (who better knows when stock is cheap than management)
3) Debt tax-shield (drives up net debt, thus closer to optimal capital structure)
4) Tax efficient for shareholders (dividend vs capital gains tax)
Against a price increase:
1) Could imply that there are no more positive NPV projects
Target has P/E of 15x, now lets say that the transaction is changed so that the acquirer gets debt from the market at 5% and then uses this money as cash for the acquisition, whether the deal is still accretive or dilutive?
i) Calculate the acquirer’s P/E, which has now become 1/interest rate *(1-t)
ii) We assume tax rate = 0, so acquirer’s
P/E is now 1/5% = 20
iii) Given in the question above, target’s P/E is 15, thus the deal is accretive
