Brainscape's Knowledge GenomeTM

Browse over 1 million classes created by top students, professors, publishers, and experts.


See full index

Corporate Valuation > DCF > Flashcards

DCF Flashcards

1
Q

Generally speaking, what adjustments are made to turn the unlevered FCF into a levered FCF?

A

Subtract interest expense, add interest income, and subtract mandatory debt repayments.

This is in ADDITION to the already excluded changes in OWC and subtraction of CapEx

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

Wait, why isn’t the PV of the terminal value just the company’s EV? Also, couldn’t you just use a multiple of EBITDA to get EV?

A

The PV of the terminal value is the PV for far in the future earnings, and you need to incorporate near earnings as well. It is much more realistic to project FCFs within a period of 5-10 years, and much more uncertain beyond that time frame. Thus, EV needs to incorporate the PVs of near term and long term earnings.

Yes, a multiple of EBITDA to get EV is one way to get an implied valuation of a company. A DCF provides another perspective to reach EV.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q
  1. When you’re calculating WACC, are convertible bonds treated as debt?
  2. If a company has different growth rates and potentially different future capital structures, how would you structure the DCF?
  3. How does NI attributable to noncontrolling interests factor into a DCF?
  4. How does NI from equity interests factor into a DCF?
A
  1. If the convertible bonds are out-of-the money, then yes. If they’re in the money, then that increases shares outstanding
  2. You’d create a multi-stage DCF that factors in diffferent growth rates and WACC
  3. NI to noncontrolling interests should not be included in FCF calculation
  4. NI from equity interests should be removed NI since there is no cash increase, thus not affecting the DCF
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

As an approximation, do you think it’s okay to use EBITDA - changes in OWC - CapEx

A
  1. Yes and no. For a very quick approximation, yes, but remember that you exclude taxes completely. It would be better to do EBITDA - taxes - changes in OWC - CapEx
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

Explain to me the idea of Ke.

A

Cost of equity is the rate equity investors require for investing in the company and given the company’s risk profile.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

Which risk free rate should you use?

What is (Rm-Rf)?

What is beta?

A

The rate reflecting the years commensurate with the number of years projecting free cash flows.

(Rm-Rf) is the market risk premium, which is the premium investors expect for investing in non-risk free assets.

Beta shows the relative volatility of a stock compared to the market.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q
  1. Do mid-year conventions produce higher or lower valuations compared to full-year periods (eg: 1 , 2 , 3 , 4)
  2. What’s the point of a stub period?
A
  1. Higher valuations because your discounting items for a lesser period
  2. You’re performing valuations before or after a fiscal year end, so there is a period of time in between the start of the next year that you need to account for. For example, if it’s currently Sep 30 and the FYE is Dec 31, then you need to project FCF for those 3 months.

Your first period is .25, then second period would be 1.25 (.25 + 1 year). etc

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q
  1. What are the 2 ways to derive Ke?
A

Rf + b(Rm-Rf)

Rf= risk free rate

b= Levered beta

Rm= expected return on the market

Or

(Dividends per share / share price) + Dividends growth rate

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q
  1. What is the difference between a DCF and the dividend discount model?
  2. Show me the formula for a DDM.
A
  1. A DCF derives enterprise value (assuming using unlevered FCFs), whereas DDM derives equity value
  2. a) project future dividends as a % of NI
    b) discount using Ke
    c) derive terminal value using perpetuity method / terminal method and discount to PV (terminal multiple P/E)
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q
  1. What’s the point of adjusted for changes in OWC (operating working capital)
A
  1. It allows us to get to a more realistic version of operating cash flow. In short, if assets are increasing more than liabilities, that means companies are using cash to increase their assets, thus REDUCING cash flow.

On the other hand, if liabilities are increasing greater than assets, that means cash flow is INCREASING.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q
  1. What are the 2 types of betas?
  2. What are the 2 types of levered betas?
  3. Beta measures what?
  4. Which type of beta is lower than the other? Why?
  5. What are the steps to derive a calculated beta (aka unlever and re-lever)
A
  1. Unlevered and levered
  2. Historical beta and calculated beta
  3. The relative riskiness or volatility of a company compared to the market
  4. Unlevered beta is lower because it does not incorporate the riskiness of debt. Levered beta is higher because it includes the risk factor of debt
  5. a) find a comparable list of companies
    b) unlever their betas using the following formula:

levered beta / ((1 + (1 - tax rate)) x (debt / equity value))

c) find the median value
d) re-lever the unlevered beta using the formula”

unlevered beta * ((1 + (1 - tax rate)) x (debt / equity value))

The above re-levering takes into account the company’s debt, equity, and tax rate.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

Calculate WACC

Risk Free rate 4%

Market risk premium 7%

Levered beta 1.3

Market value of debt $350

Market value of equity $650

Tax rate 35%

Cost of debt 6.6%

A

10%

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q
  1. What is more ideal to use, a company’s targeted capital structure or current capital structure?
  2. The optimal capital structure minimizes what?
A
  1. Targeted capital structure is more ideal if you can project that, but that is difficult to project
  2. Minimizes cost of capital
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q
  1. What is the FCF formula?
  2. How do you determine how many FCF periods to project?
  3. Which of the 3 parts of the cash flow statement does unlevered FCF exclude?
A
  1. EBIT (1-T) + non cash charges - changes in OWC - CapEx

NWC should be operating working capital.

  1. Generally, the period is 5 - 10 years. The period needs to end at or slightly after the time the company reaches a “steady state”. A steady state has many characterizations, one of which is when a company’s CapEx is used to offset depreciation.
  2. Cash flows from financing and some parts of cash flows from investing
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

What is the formula for WACC?

A

(E/(E+D+P))*Ke + (D/(E+D+P))*(1-T)*Kd + (P/(E+D+P))*Kp

E=Market value of equity (share price x diluted shares)

D= Value of debt

P= Value of preferred stock

Ke= cost of equity using CAPM

Kd= current interest rate on debt

Kp= effective yield

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q
  1. Why do you use FCF? What is so important about that?
A
  1. FCF essentially replicates the cash flow statement, but excludes non-recurring cash flows such as particular investing cash flows and financing cash flows such as debt and equity issuances

It more refelcts operating cash flow while including the impact of CapEx

17
Q

Calculate the equity value per share:

Assume the PV of unlevered FCF is $500 million. The PV of the unlevered terminal value is $3,000 million. Net debt is $200 million. Cost of equity is 11% and WACC is 9%. There are 100 million diluted shares outstanding.

A

$33

18
Q

How do you get the value of debt?

A companies Kd is comprised of which two aspects?

How is the cost of debt derived? How do you derive it if the company’s debt is not publicly traded?

A

Most professionals use book value of debt. However, it is important to adjust that if the market value of the debt is significantly different.

The cost of debt is a risk free rate (typically 10 or 30 year T-Bond) plus a spread to adjust for the company’s risk profile. If the company’s debt is publicly traded, you can directly observe the rate.

If the company’s debt is not publicly traded, I would examine the company’s footnotes looking for a rate, check for latest debt issuances, use a comparable company’s rate, or ask a debt markets professional

19
Q

What are the 2 methods to calculate terminal value?

A

Terminal multiple and perpetuity method

20
Q
  1. What has a greater impact to a DCF value, a 1% change in revenue or a 1% change in the discount rate?
  2. Do smaller companies tend to have a higher or lower Ke?
  3. What does additional debt do to Ke? Why?
  4. What does additional debt do to WACC? Why?
  5. Higher interest rates do what to WACC? Why?
A
  1. Discount rate change
  2. Higher, because they are expected to grow more
  3. Raises cost of equity because it makes the entire company riskier (leveraged to generate greater returns). It increases the levered beta, thus increasing cost of equity.
  4. It lowers WACC, because cost of debt is cheaper than cost of equity and you’re using a larger % of cheaper capital. It offsets the increase in Ke due to an increased beta.
  5. Increase WACC because it makes debt more expensive
21
Q
  1. How would you ensure that the perpetuity method and terminal multiple method are compatible?
A
  1. I would apply the gordon growth method to derive the terminal value and then divide it by EBITDA to get a multiple. I would then compare that multiple to the terminal multiple to see if they are compatible.
22
Q

Give me a high level summary of how to perform a DCF.

A

Project FCFs for a certain period (5 to 10 years)

Calculate the WACC

Calculate the terminal value using Terminal multiple or perpetuity method

Discount and sum

23
Q

How do you derive equity value/share when you’ve calculated enterprise value via a DCF?

A

Subtract value of debt, value of preferred stock, value of minority interest and add cash/equivalents. Then, divide by diluted shares outstanding.

24
Q
  1. Higher cost of capital leads to ____ valuations?
  2. Lower cost of capital leads to ____ valuations?
  3. What is the most common way to calculate terminal value? How is it derived?
A
  1. Lower
  2. Higher
  3. Terminal multiple method. You derive multiples from comparable companies and apply it to the latest projected EBITDA.

Also, you would use a range of multiples from the comps set

25
Q

Beta measures which type or risk- firm wide risk or market specific risk?

Explain how you calculate beta.

In CAPM, describe B(Rm-Rf).

A

Market specific risk

Beta is calculated by taking the correlation of a stock’s return to the market return over a specific timeframe.

B(Rm-Rf) is the risk premium. Beta measures relative volatility of a stock compared to the market, and then Rm-Rf is the market risk premium. So, you have to multiply that by the beta.

26
Q

What is the perpetuity growth method to derive terminal value? Show the formula.

A

Apply a low, single digit growth rate. Typically, something greater than inflation, but no more than the growth of the economy.

FCFn x (1+g)/(WACC-g)

Discount it according to the number of periods that you projected FCFs.

27
Q
  1. What discount rate do you use with a unlevered FCF?
  2. What discount rate do you use with a levered FCF?
  3. If you use unlevered FCF, which beta do you use?
  4. If you use levered FCF, which beta do you use?
  5. Discounting levered FCFs derives which value?
  6. Discounting unlevered FCFs derives which value?
A
  1. WACC
  2. Ke (Cost of equity)
  3. Levered beta
  4. Levered beta
  5. Equity value
  6. Enterprise value
28
Q

You’re looking at two companies that have the same total projected FCF over a 5 year period. Company A generates 90% of its FCF in year 1, and 10% throughout the rest of the years. Company B generates FCF equally over the 5 years. Both have the same discount rate.

Which company has a higher value based on a DCF?

A

Company A has a higher valuation. Money today is worth more than the same amount of money in the future.

29
Q

Who has the higher PV of the terminal value?

Assume that company A has a WACC of 10% and comapny B has a WACC of 8%. Both companies have a projected year 5 terminal EBITDA of $100 million, but company A’s exit multiple is 10x and company B’s is 8x.

A

Company A

30
Q
  1. When you divide a number by 1, you get what?
  2. When you divide a number by a number > 1, you get what?
  3. When you divide a number by a number < 1, you what what?
A
  1. The same number
  2. A number lower than the numerator
  3. A number greater than the numerator
31
Q

What is the terminal multiple method?

A

It applies a valuation multiple such as EV/EBITDA, to the final year’s forecasted metric. For example, a company could have a 8x EV/EBITDA multiple, which it would apply to the final year’s projected EBITDA.

The terminal value is discounted according to the final period FCF was projected.

It is important to use an EV multiple

32
Q

Other than being a company’s cost of capital, what is another way to view WACC?

A

It is the blended rate of return the company’s debt and equity investors require to cover the risk of investing in the company.

Corporate Valuation (7 decks)

Brainscape helps you reach your goals faster, through stronger study habits.
© 2024 Bold Learning Solutions. Terms and Conditions