DCF

Question 1

What is a DCF?

Answer 1

A DCF is premised on the principle that a company is worth the present value of its future cash flows. In practice, a DCF combines the present value of its future cash flows for a projected period of time, and then the present value of the terminal value of the company at the end of the projection period to capture the remaining value of the firm past this point in time. The discount rate and type of cash flows depend on what type of valuation you’re looking for. The sum of the two present values gives the valuation of the firm.

Question 2

How do you calculate a company’s free cash flow?

Answer 2

1) Project out the company’s revenue growth (5-10 years). Determine projected annual revenue based on historical numbers
2) Next assume an operating margin for the company in order to calculate EBIT. This is typically based on historical margins.
3) Apply the company’s effective tax rate to calculate NOPAT or EBIAT
4) Next, you project the Cash Flow Statement and project Non-Cash Charges, Changes in operating Working Capital, and Capital Expenditures
5) You add back non-cash charges such as depreciation and stock-based compensation, typically a percentage of revenue.
6) Next you estimate the change in Operating Working Capital, typically a percentage of revenue and add/subtract this figure
7) You estimate Capital Expenditure which can either be a constant or percentage of revenue and subtract this.
8) You take NOPAT and adjust for all the above changes to find UFCF.

Question 3

How to adjust for LFCF?

Answer 3

After finding EBIT, you adjust for net interest expenses and then apply tax. You also need to subtract and mandatory debt repayments.

Question 4

Do larger or smaller companies have higher Discount Rates?

Answer 4

All else being equal, smaller companies tend to have higher Discount Rates because investors expect that they will grow more and deliver higher growth, profits, and returns in the future. They also are “riskier”.

Question 5

Do companies in emerging or established markets have higher Discount Rates?

Answer 5

Companies in emerging markets have higher discount rates because the potential growth, returns, and risk are all higher.

Question 6

How does discount rate work for a company?

Answer 6

Discount rate separates out the cost of financing for each individual investor group (based on the firm’s capital structure). Typically this is equity investors, debt investors, and preferred stockholdeers.

Question 7

How do we calculate the cost of debt?

Answer 7

We could use the interest rate on debt to find the cost of debt. But this is dependent on how close the market and book values of debt are.

Question 8

How do we calculate the cost of preferred stock?

Answer 8

We look at the Effective Yield on Preferred Stock (% dividends of the amount issued $100 issued, $7 preferred dividend = 7%).

Question 9

How does issuing equity cost the company?

Answer 9

Equity costs the company in 2 ways:

1) The company issues dividends to common shareholders (Cash Expense)
2) The company is offering future stock price appreciation to someone else rather than keeping it for itself

Question 10

What is the cost of equity?

Answer 10

Risk-free rate + levered beta * market risk premium

Question 11

What is the risk-free rate?

Answer 11

This is the rate of return of investing in a risk-less security, such as the yield on a 10 US treasury bond. The current value for this is 0.95%.

Question 12

What is the equity risk / market risk premium?

Answer 12

This is the extra yield you could earn by investing in an index that tracks the stock market in your country. In theory, it looks at what extra % we could make if we chose to put our money in the stock market rather than a safe, risk-less security.

Question 13

What number do we use for the equity risk premium?

Answer 13

Anywhere between 3-10%. Typically you take this figure from Ibbotson’s.

Question 14

What is beta?

Answer 14

Beta is the riskiness of the company relative to all other companies in the stock market.

Question 15

What beta do we use?

Answer 15

You could use the historical beta for the market however more popularly, you make your own estimate for Beta.

Question 16

How do we make our own estimate for Beta?

Answer 16

You use public comparable companies for the company you’re valuing and assume that the company’s true beta is different from its historical beta.

This is to understand whether the riskiness of the company is in-line with how risky similar companies in the market are.

Question 17

How do we unlever Beta?

Answer 17

Unlever B = Levered B / (1 + (1-T)*(D/E))

We unlever to isolate inherent business risk.
This represents the company’s intrinsic risk when we remove additional risk from Debt. What the formula tells us is that we are removing the risk from debt that is proportional to its gearing ratio.

Question 18

A company’s levered beta is 1. It’s tax rate is 40% and has 200M in debt and Equity Value of 1Billion. What is its unlevered beta ?

Answer 18

Certainly. So we are going to proportionally remove the risk of debt based on the gearing ratio.

so unlevered beta = levered beta / (1 + (1-T)*D/E)

= 1/(1+(0.6)*(1/5)) = 1 / (1 + 3/25) = 1/1.12 = 25/28

Question 19

What does this tell us?

Answer 19

If we ignore the debt of the company, it is less risky than the market, overall. So if the market moves upward by 10%, our company’s stock price will increase by 8.9%.

Question 20

What does relevering beta mean?

Answer 20

By re-levering beta, we increase our Unlevered Beta by however much additional risk the Debt adds, also taking into account that the tax-deductible interest reduces risk as well.

Question 21

What is an alternate formula for cost of equity?

Answer 21

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

We generally don’t use this since not all companies issue dividends but it is useful for companies in specific industries that offer dividends with predictable growth rates.

Question 22

Is preferred dividends tax-deductible?

Answer 22

No, preferred dividends are not tax-deductible and it is why we don’t adjust for tax in the WACC calculation.

Question 23

What does debt usually do for WACC?

Answer 23

Debt will almost always decrease WACC because cost of Debt is lower than Cost of Equity (since interest rates are lower and interest is tax deductible)

Question 24

What does Preferred Stock do for WACC?

Answer 24

Preferred stock is generally cheaper than Equity but not as cheap as debt since dividends are not tax-deductible.

Question 25

What does Equity do for WACC?

Answer 25

Equity tends to cost the most. Intuitively you expect to earn more from investing in the stock market over bonds.

Question 26

How do Risk Free Rates affect Cost of Equity?

Answer 26

Higher RFRs increase cost of Equity

Question 27

How do Equity Risk Premiums affect Cost of Equity?

Answer 27

Higher ERP increase Cost of Equity

Question 28

How does Debt affect cost of Equity?

Answer 28

Higher debt increases cost of equity because if a company has debt, investing in its equity also becomes riskier because debt increases the chances of the firm defaulting and leaving you with nothing.

Question 29

Should we use the companies historical or current capital structure in our beta calculation?

Answer 29

In real life it’s difficult to know how a company’s capital structure will change so far in advance however if we have access to that type of information, we would ideally use the company’s targeted/planned capital structure to provide us with accurate representation of the company for our discount rate.

Question 30

What is a disadvantage with the Exit Multiple Method in calculating terminal values?

Answer 30

The downside of exact multiples is that they are hard to estimate years in advance so you have to use a range of multiples as part of a sensitivity table.

Question 31

What is the Perpetuity Growth Method?

Answer 31

You estimate the terminal value by finding the perpetual value of the free cash flow growth of the company, relative to its discount rate.

= Final Year FCF * (1 + terminal FCF growth rate) / (WACC - terminal FCF growth rate)

Question 32

What is an appropriate terminal growth rate?

Answer 32

Usually you use a growth rate lower bounded by a country’s inflation and upper bounded by a country’s GDP rate.

Question 33

Which method is better to calculate a terminal value?

Answer 33

Neither is better, and typically you would use both to help validate your results.

The main disadvantage with both is that the Terminal Multiple and Terminal Growth Value are difficult to determine precisely.

Question 34

When may the Gordon Growth model be more useful?

Answer 34

If the industry is cyclical or multiples are hard to predict.

Question 35

What factors have the largest impact on a company’s present value?

Answer 35

Discount Rate and Terminal Value tend to have the largest impacts here, with discount rate having the largest impact (for similar changes - 1% + or - )

Question 36

Why does discount rate have such a large impact?

Answer 36

Discount rate affects everything in the analysis - from the present value of cash flows to the present value of the terminal value

Question 37

What are some rules of thumb for Cost of Equity?

Answer 37

1) Smaller companies generally have higher cost of equity because expected returns are higher
2) Companies in emerging geographies and fast-growing markets also have higher cost of equity for the same reason
3) Additional Debt raises the cost of equity as it makes the company riskier for all investors
4) Additional Equity lowers the cost of Equity because the percentage of debt in a company’s capital structure decreases
5) Using Historical vs. Calculated beta doesn’t have a predictable impact

Question 38

What are some rules of thumb for WACC?

Answer 38

1) Assuming that the companies have identical cap structure, smaller companies / companies in emerging geographies have higher costs of equity.
2) Additional Debt reduces WACC because debt is less expensive than equity. Yes, Levered Beta will increase and so will cost-of-equity but the additional debt will likely make up the difference for WACC.
3) Additional preferred Stock will generally reduce WACC since its less expensive than Common Stock
4) Higher debt interest rates will increase WACC because they increase the cost of Debt.

Question 39

How is a DDM (dividend discount model) different from DCF?

Answer 39

With a DDM, you set up the analysis in the same way.

The difference is that you do not calculate free cash flow, rather, you stop at Net Income and assume dividends issued are a % of Net Income and discount these dividends back to their present value using the Cost Of Equity of the firm.

We also discount back the terminal value using cost of equity, and the terminal value may be calculated using a P/E multiple instead.

This yields the Equity Value.

Question 40

What is the point of FCF?

Answer 40

The idea is that you are replicating the Cash Flow Statement to show only recurring and predictable items (while ignoring effects of financing).

Question 41

Why do you add back non-cash charges in Free Cash Flow?

Answer 41

You want to reflect the fact that the company saved on taxes but not actually paying the expense in cash

Question 42

How can we calculate UFCF in different ways?

Answer 42

1) EBIT*(1-Tax) + noncash charges - changes in working capital - capex
2) CFO + tax adjusted net interest expense - Capex
3) Net income + Tax-adjusted net interest + non cash charges - changesin working cap - capex

Question 43

What happens if the FCF is negative?

Answer 43

You could still use the analysis if at a certain point the company’s cash flow became positive, otherwise you may decide to use a different method.

Question 44

Can we use EBITDA to approximate UFCF?

Answer 44

We could but we would be ignoring the effects of taxes, working capital changes, and capital expenditures.

Question 45

Why do you use levered beta with Cost Of Equity?

Answer 45

You always use Levered Beta because Debt makes the company’s stock riskier for everyone involved.

Question 46

Consider WACC during a crisis. Does it increase or decrease?

Answer 46

Cost of Equity:

Typically during crises, the risk free rate would drop as the governments worldwide would drop interest rates to encourage spending.

Equity Risk premium is likely to increase a lot as investor demand high returns for their stocks.

Beta will also increase as a result of volatility.

COE - ^^^

Cost of Debt / preferred:

Cost of Debt will increase as it becomes more difficult for firms to borrow money.

The Debt-Equity ratio will likely increase as well as the company’s share price falls and thus Equity falls (while debt stays the same).

Proportionally Debt and Preferred stock would make up a higher proportion of a company’s capital structure.

Since both of these are increasing in value too, WACC almost certainly increases because all variables, other than risk-free asset pushes it up.

Question 47

Why would you use the GGM over Exit Multiples Method?

Answer 47

1) If there are no strong comparable companies to generate realistic or confident ranges for multiples (market data may not be reliable or it may be spotty)
2) You have reason to believe these multiples may not be representative in the projected period (cyclical industry)

Question 48

Let’s say revenue growth is 10%, WACC is 10%. What would have a bigger impact on valuation - Revenue changing to 9% or WACC changing to 9%.

Answer 48

Likely WACC changing to 9% as it affects everything in the DCF, from FCF to PV of Terminal value. This 10% change will affect it more.

Question 49

Now Revenue changes to 1% and WACC stays at 9%.

Answer 49

Now we are changing revenue by 90%! This will likely have a bigger impact on valuation since FCF will decrease significantly.

Question 50

If FCF in projection period increase by 10% each year, how will the Enterprise Value change?

Answer 50

The Enterprise value will increase by some value less than 10%.

1) The FCF increase by 10% but still need to be discounted back to PV
2) The terminal value of the firm is not affected by the 10% growth rate into perpetuity so the company’s total value is not explicitly affected.

Question 51

Why do we use a mid-year convention?

Answer 51

We use it to represent the fact that cash flow does not arrive all at the end of each year rather it comes through evenly during the year. To account for this, we take the average point for the cash flow during the year, thus mid year, and discount based on this.

Now we discount based on 0.5 for yr1 , 1.5 for yr2, 2.5 for yr3 etc

This end result would produce higher values since discount periods are all lower.

Question 52

What is a stub period?

Answer 52

You use this when you are valuing a company before or after its fiscal year and there are 1 or more quarters in between the current date and the end of the fiscal year.

So if there is 1 quarter difference, we use 0.25 for the stub period, then 1.25 for the first full year, and then 2.25 etc. onwards.

Question 53

How do we adjust the stub period and mid year convention.

Answer 53

Now we need to account for the average cash flow time period for the stub and future periods.

So for the stub period, we take the midpoint of the stub (by dividing by two).

And for future periods, we subtract half a year to represent the midpoint between the stub and the first full year.

Question 54

How does terminal value change based on mid-year convention?

Answer 54

For MM: you add 0.5 to the final year discount number to reflect that you’re assuming the company gets sold at the end of the year

For Gordon Growth Method: you use the final year discount number as is because you assume the free cash flows grow into perpetuity and they are still received throughout the year rather than at the end.

Question 55

How does a DCF for a private company differ?

Answer 55

The mechanics are the same but Calculating Cost of Equity and WACC may be more difficult as you can’t find market value of Equity or Beta for private companies.

WACC may be based on the median of public comparables and similarly for Cost of Equity too.

Question 56

How do you factor in one-time events such as raising Debt, completing acquisitions, etc. in a DCF?

Answer 56

Normally you would ignore these events because the point of FCFs is to determine the recurring, predictable cash flows of a company.

If you are certain of an event, you could account for it (new debt issued will increase cost of Equity and WACC, as well as Levered FCF) or completing an acquisition would reduce cash flow initially but boost it later

Question 57

How does a DCF change if you’re valuing a company in an emerging market?

Answer 57

The main difference is that you may not link discount rate to WACC or Cost of Equity as there may not be good public comparables to use as a proxy for your analysis. As well, you may have to adjust discount rate for political instability and be more cynical in expectations.

Question 58

How do you treat Mezzanine debt in beta calculation? How about for WACC?

Answer 58

If the debt is tax-deductible, you count it toward the proportion of debt, whereas if not, you count it toward equity, just like the preferred stock.

For WACC, you look at the debt separately and take the weighted average effective interest rate on Debt.

Question 59

How do Pension Obligations and Pension Expenses factor into DCF?

Answer 59

If you’re running an unlevered DCF, they should not factor in since they are equivalent to debt (unfunded or underfunded pension obligations) thus you should exclude expenses related to those on income and cash flow statements.

For LFCF you would do the opposite as these form part of interest expense.

Question 60

How does Net Income Attributable to NCI factor into FCF?

Answer 60

It doesn’t factor in as it is subtracted from the Income Statement and added back to the Cash Flow statement.

Question 61

How does Net Income from Equity Interests factor into FCF?

Answer 61

This has no net impact as it is added to the Income Statement and subtracted from the Cash Flow Statement

Question 62

What tax rate should you use in a DCF?

Answer 62

You use effective tax rate as you want to capture the tax paid out, rather than what it should be paying out according to standard federal and state rates.

Question 63

We are looking at a company’s DCF. It wants to buy a factory for $100 in yr 4. Its NPV is $200. How does our Enterprise value change>

Answer 63

So in year 4, our UFCF will decrease by $100 due to the capital expenditure. Thus, our Enterprise value will decrease by 100/(1+WACC)^4.