DCF Advanced

Question 1

Explain why we would use the mid-year convention in a DCF?

Answer 1

You use it to represent the fact that a company’s cash flow does not come 100% at the end of each year instead it comes in evenly throughout each year.

“Convention” meaning a standard or guideline

In a DCF without mid-year convention, we would use discount period numbers of 1 for the first year, 2 for the second year, 3 for the third year, and so on.

With the mid-year convention, we would instead use 0.5 for the first year, 1.5 for the second year, 2.5 for the third year, and so on.

Mid-year a compromise assuming FCF’s received in the middle of the annual period

Continuous cash flow, as in all cash proceeds received at the end of each year.

Earlier cash flows reduce the time each cash flow is discounted so higher PV

Question 2

What discount period numbers would I use for the mid-year convention if I have a stub period - e.g. Q4 of Year 1 in my DCF?

Answer 2

The rule is that you divide the stub discount period by 2, and then you simply subtract 0.5 from the “normal” discount periods for the future years.

Normal Discount Period with Stub “Short or partial period”
Q4 Y1 Y2 Y3 Y4
0.25 1.25 2.25 3.25 4.25….

Mid year discount period with stub

Q4 Y1 Y2 Y3 Y4
0.125 0.75 1.75 2.75 3.75

Question 3

How does the terminal value calculation change when we use the mid-year convention?

Answer 3

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

Gordon Growth Method: Final discount number as is because you’re assuming cash flows grow into perpetuity and that they are still received throughout the year.

Question 4

If I’m working with a public company in a DCF, how do I calculate its per-share value?

Answer 4

Once you get to EV add cash and then subtract debt, preferred stock, and non-controlling interest (and any other debt-like items) to get to equity value.

Then you need to use a circular calculation that takes into account the basic shares outstanding, options, warrants, convertibles, and other dilutive securities.

It’s circular because the dilution from these depends on the per-share-price but the per-share-price depends on number of shares outstanding which depends on per-share-price.

To resolve this you need to enable iterative calculations in excel so that it can cycle through to find an approximate per-share-price.

Value of equity/outstanding share = Fair value per share

Question 5

Walk me through a dividend discount model (DDM) that you would use in place of a normal DCF for financial institutions.

Answer 5

Same mechanics but dividends rather than free cash flows.

1. Project out earnings down to EPS
2. Assume a dividend payout ratio, what percentage of the EPS gets paid out to shareholders in the form of dividends.
3. Use to calculate dividends over the next 5-10 years
4. Do a check to make sure that the firm still meets its target Tier 1 capital and other capital rations - if not reduce dividends.
5. Discount the dividend in each year to its present value based on cost of equity, not WACC and then sum these up.
6. Calculate terminal value based on P/BV and Book Value in the final year and then discount this to its present value based on Cost of Equity
7. Sum the present value of the terminal value and the present values of the dividends to get the Companys net present per share value.

Question 6

When you’re calculating WACC let’s say that the company has convertible debt. Do you count this as debt when calculating Levered Beta for the company?

Answer 6

Trick question, if the convertible debt is in the money than you do not count it as debt but instead assume it contributed to dilution, so the company’s Equity Value is higher.

If out of the money, then count as debt and use the interest rate on the convertible for the cost of debt.

Question 7

We’re creating a DCF for a company that is planning to buy a factory for $100 in cash (no debt or other financing) in Year 4. Currently the present value of its EV according to the DCF is $200. How would we change the DCF to account for the factory purchase and what would our new EV be?

Answer 7

In this scenario you would add CapEx spending of $100 in Year 4 of the DCF which would reduce FCF for that year by $100.

The EV in turn would fall by the present value of that $100 decrease in FCF.

The actual math is messy, but you would calculate the PV by dividing $100 by ((1+DR) ^4)

The “4” just represents year 4.

Then you would subtract this amount from the EV.