DCF Flashcards
Walk me through a DCF
- Calculate Free Cash Flow
- Calculate Terminal Value
- Discount Stage 1 + Stage 2 by the weighted average cost of capital
- Subtract Debt and add Cash to get Capital Value
What is the appropriate discount rate to use in an unlevered DCF analysis?
Weighted Average Cost of Capital
What is typically higher – the cost of debt or the cost of equity?
Cost of Equity because the cost of debt is tax deductible
How do you calculate the cost of equity?
Equity Risk Premium * Beta + Risk Free Rate
How do you calculate unlevered free cash flows for DCF analysis?
EBIT * (1- tax rate) + depreciation and amortization - change in capital - Capex
What are the advantages and disadvantages of the DCF approach?
Advantages: fundamental oriented, being a more academic rigorous approach and also market independent
Disadvantages: Fixed capital structure , highly sensitive to the assumptions made and the terminal value has a big impact on the valuation
Conceptually, what does the discount rate (WACC) represent?
Represents the expected return on investment given it’s profile
What is the difference between the unlevered DCF and the levered DCF?
Unlevered DCF it’s pre debt, therefore there is no interest expense or tax benefit. Through it we arrive at the enterprise value. The discount rate is WACC.
Levered DCF arrives at the equity value directly and the discount rate used it’s cost of equity.
What is the formula to calculate the weighted average cost of capital (WACC)?
Cost of Equity * Equity Weight + Cost of Debt * Debt Weight
How can the risk-free rate be determined?
It’s when the actual return it’s equal to the expected return, usually it’s used government bonds
What does the equity risk premium (ERP) represent?
It’s the incremented from investing in the equities market rather than risk-free security rates
When would a DCF be an inappropriate valuation method?
- Limited Financials
- Unprofitable Start-Ups
How would you value a company with negative historical cash flow?
DCF - profitability will make the multiples analyses meaningless
What are net identifiable assets?
In simple terms, it’s the total value of everything the target company owns, minus everything it owes, that the buyer can specifically pinpoint and measure. This value helps the buyer decide on a fair purchase price and see how much extra they’re paying over the company’s book value, often recorded as “goodwill” on the balance sheet.
What are the two methods to calculate the terminal value (TV)?
- Perpetuation
- Exit Multiple
